Risk Aversion Trade to Push Dollar Higher
February 5, 2010
Although world economic prospects are not shabby in their aggregate, the gap between dynamic emerging markets and schlerotic advanced ones keeps widening. Australia’s quarterly Monetary Policy Statement, published today, asserts that “the world economy is now widely expected to grow by around 4% in each of the next couple of years,” yet the risk aversion trade has returned to dominate financial markets. As in 2008-9, this benefits the dollar.
The U.S. currency as of 16:00 GMT today had appreciated for the week by 1.9-2.4% against the kiwi, sterling and Australian dollar and by 1.4% against the euro and 1.3% versus the Swiss franc. In the ten weeks since Thanksgiving, the dollar has advanced 10.7% against the euro, 8.4% against the Swissy, 7.9% relative to the Aussie dollar, 6.5% versus the New Zealand dollar, 5.5% against sterling, 2.3% against the Canadian dollar and even 4.0% against the yen, which like the dollar tends to be favored in times of elevated risk aversion.
Europe has been the object of greatest investor concern. Regional growth seems to have lost a step in late 2009, with German industrial orders and output plunging 2.3% and 2.6% in December and ECB leaders predicting only tepid growth as several stimulants in 2H09 fade. The European Monetary System was born with a birth defect, the failure to properly engineer a disciplining force on fiscal policy that would be as good in practice as on paper. Without such, there is always a possibility that some members may abandon the common currency and an even greater likelihood that well-functioning members are forced to underwrite other members to prevent them from defaulting. These possibilities create an ever-present cloud of uncertainty that, without resolution, forever prevents the euro from rivaling the dollar as the most favored reserve currency. Such qualms weighed heavily on the euro in its first two years, then went into remission, but were stirred up anew by the Great Recession and the common currency’s expanding membership.
Britain and Japan are in difficult situations that further feed investor uncertainty. No country in the Group of Seven has a worse mix of growth and inflation than Britain, where GDP contracted 5.2% between 4Q07 and 4Q09 and consumer prices advanced 2.9% in the past twelve reported months. In once mighty Japan, whose financial wheels ran off the road some 17 years before the subprime credit crisis, investors see the frightening future that may await other advanced economies. Stuck in deflationary mud, Japanese real GDP grew on average 0.7% per annum over the 18 years between 3Q91 and 3Q09, and the Bank of Japan is in its fifteenth year of not managing to raise its key interest rate above 0.50% despite wanting to tighten.
China is the world’s economic growth poster child now, but Beijing’s bullying foreign policy feeds risk aversion, too. A key element of the be-reasonable-do-it-my-way attitude toward other governments is the de facto policy that pegs the yuan to the dollar. That mercantilist strategy promotes an export- and investment-led blend of economic growth that makes China unsuitable for the role of world growth engine, and it blocks the reduction of global imbalances that were a root cause of the Great Recession.
A great paradox of the risk aversion trade is that it allows bad U.S. economic news to boost the dollar, an opposite dynamic from what one usually observes. The United States entered the teenies decade in a much bigger labor market hole than realized before today’s benchmark revisions. Wire service reports today stressed the unexpected mitzvah of a lower 9.7% unemployment rate. A bigger story looking ahead lies in the revised 8.42 million drop in jobs since end-2007. It turns out that the employment level at the end of 2009 was 1.36 million workers less than measured previously, and that worse reality is largely because of much greater layoffs in 2008 than reported previously. Employment fell 191K per month in the second quarter of 2008, 334K per month in 3Q08, and 652K per month in 4Q08 before powering up to a 753K per month rate of decline in the first quarter of 2009 and a drop of 478K per month in 2Q09. Yes, the labor market is stabilizing now, but consider this fact: Jobs fell 985K or 0.1% per annum in the noughties after gains of 21.7 million (1.8% per annum) in the 1990s, 18.1 million (also 1.8% per annum) in the 1980’s, and 19.4 million (2.4% per annum in the 1970s). Had employment also climbed 1.8% per annum in the last decade instead of declining by nearly one million workers, the level of employment would be 27 million people higher now than it is. And if jobs were to expand half as fast in the coming decade as they did in each of the last two decades of the twentieth century, the level of employment at the end of 2019 will be 46 million less than if such had continued to rise at an annual rate of 1.8% during the first two decades of the twenty-first century.
The broken state of American politics is equally worrisome. Representative government no longer seems able to deliver decisions on anything. It’s not a coincidence that the main news on January 19th after which stock markets turned south was Scott Brown’s election to the vacant senate seat of Massachusetts. If investors were merely worried about the size of the U.S. budget deficit, that victory and accompanying death of healthcare legislation along lines moving through congress should have given cause for market celebration. On the more profound issue of demonstrating that nothing is going to get done in Washington, it made sense for investors to bail out. The most successful economies in this century are ones that adopt capitalistic pricing mechanisms but retain authoritarian political systems and eschew democracy.
U.S. stock prices have so far only lost about a third of the ground necessary to rank the decline as a bear market. That’s where I believe markets are headed eventually, not merely because economic circumstances will weaken but rather because they will not be nearly robust enough to justify the recovery from early March 2008 through the middle of last month. Because of adverse feedback loops, a 20% or bigger drop in equities will also put the economy on a weaker growth vector than if the status quo instead could somehow be preserved from here. In this environment, slack in the economy will be taken up much more slowly, inflation will stay low, and the conventional view now that Fed rate increases begin to happen around the middle of this year will not play out. If equities suffer through a bear run, moreover, long-term interest rates will not rise much this year and remain historically low despite worrisome budget red ink now and projected in the distant future. But the dollar should stay well-bid because investors will be encouraged to seek security, not greater risk.
It helps too that the dollar presently seems to be trading below its historic center of gravity. It is 14% weaker against the euro than its average level since the common currency was launched at the start of 1999, and the buck is 20% below its yen mean over the same 133-month-long period. Net exports made a half-percentage point positive contribution to the U.S. growth rate last quarter, further suggesting that the greenback isn’t overvalued at the moment.
Copyright Larry Greenberg 2010. All rights reserved. No secondary distribution without express permission.
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