Currency Market Uncertainties Involve Political Decisions

April 23, 2010

When currency market direction hinges on political decision-making, fundamental economic analysts and technical market guidance are not especially helpful because the deciders are not influenced by any of those factors, and their actions are game-changers.  Since the summer of 2007, private and government analysts have emphasized the unusually high level of uncertainty surrounding baseline forecasts.  They had in mind the evolution of the Great Recession, but the main uncertainties of late concern issues of politics more than economics.  It’s very difficult to trade political markets, as momentum goes no deeper than the last news headline.  To complicate matters, many political questions will be in play in the weeks ahead, rather than just one.

Greece’s debt crisis has captured the greatest attention.  That government has formally requested that a EUR 45 billion EU/IMF credit line be activated.  However, EU officials have agreed that all 16 currency unions must consent for such a deal to go forward, and German Chancellor Merkel has sustained the market’s suspense by demanding that pre-conditions under the vague umbrella of “consolidation” be met first.  What investors need to know is whether Greece gets enough short-term funds to cover liabilities due by May 19, and whether that can be accomplished without the formality of all EU members first ratifying the loan.  Having seen in the Lehman saga how much damage happens when something with a potential domino effect is not prevented, I expect a way will be found to cover Greece’s near-term obligations but also believe enough medium-term uncertainty will persist to keep Greek interest rates higher than everyone would like.  So this negative for the euro becomes less acute but does not disappear.  At 14:50 GMT today, the euro had lost 1.1% against the dollar since the close on April 16, and the U.S. currency was trading at the 67.3 percentile of its 1.3691 – 1.3198 four-week trading range.  Contrary to the hype of some headlines, the euro is not tumbling like a rock or, to make a more apt comparison, at the speed that U.S. bank shares declined in late 2008 when it was feared they might get nationalized.  Investors are not convinced the euro will break apart and remain unsure exactly how the dollar would behave even if that did happen.

The yen lost twice as much ground as did the euro this past week against the dollar and as noon in New York was trading closer to the bottom of its 94.76 – 91.86 per dollar four-week trading range.  As a percent of GDP, Japan has much more debt than anybody in Europe or North America, and its fiscal problems have been building for two decades, not two years.  Unlike Greece, Japanese long-term interest rates are very low, and real GDP is expanding.  Dire warnings of a collapsing Japanese bond market and economy have been around almost as long as the fiscal problems but still remain a hypothetical risk with very uncertain timing.  What is clear is that the DPJ government lacks the strength and willpower to enact fiscal cutbacks and could be weakened further after upper house parliamentary elections this summer.  A policy of near-zero Bank of Japan interest rates, reinforced with unconventional infusions of longer-term liquidity, is differentiating Japan increasingly from other central banks, which by varying degrees are pulling away from the emergency settings reached in the Great Recession.  The yen is a victim by contagion of the attention to European debt, reinforced by credit rating agencies that are reviewing Japan.  The ECB will be unhappy to see significant further euro depreciation, amid recent evidence of inflationary supply-side pressures.  Japanese policymakers, on the other hand, will offer no resistance to yen depreciation, which is one of their few immediate weapons against deflation.

Appreciating the yuan will be a purely political decision of Chinese policymakers.  All the leaders of the Group of Twenty, who are meeting in Washington today, can do is show solidarity in urging Beijing to make such a move sooner rather than later.  The baton of currency market surveillance and policy coordination has been passed from the narrower G-7 to the G-20, which includes China and other critical emerging economies.  Instead of getting lectured by the United States, Japan, and Europe, Chinese officials now get an earful from a group of those nations plus its own peers.  Surely this change will not erase Beijing’s aversion to caving in to foreigners, so the strategy could backfire if Chinese leaders feel cornered.  The yuan may be unpegged from the dollar within the month, or the delay could stretch longer.  The decision almost certainly will rest on a consideration of domestic benefits and risks and emerge from a debate within China’s leadership, not with the leaders of other countries.  While analysts have a wide spectrum of beliefs about when yuan appreciation begins, considerable consensus exists that it will be exceedingly gradual at first.  I share that view because that’s what happened in 2005-8.  But the biggest scope for impacting all major currency pairs would be associated with a yuan rise that is much more front-loaded than the last one, and that scenario cannot be ruled out because, politicians rather than market forces will dictate the process.

Britain’s most important election since 1979 occurs in just under two weeks.  All indications point to a hung parliament, but voter preferences remain very fluid.  British public sector borrowing excluding financial taxes soared to 11.6% of GDP last fiscal year from 2.4% two years before, and the debt ratio, which generally moves in tiny steps from year to year, jumped to 62% from 43% two year earlier.  A parliament is “hung” when no party captures a majority of seats, but the risk to sterling of a hung parliament transcends legislative paralysis.  The new government would be more leftward leaning than the outgoing one and less inclined to produce a credible long-term plan for reducing the deficit and halting the relative climb of debt.  Although some thirty-five years have elapsed since the last hung parliament, markets will be reminded if that happens about what a failure for policy, the economy and sterling the last experience was.  In spite of the looming election, sterling rose this past week against the euro, Swissy, and yen and showed a dip of just 0.2% against the dollar as of 15:00 GMT.

Reinvigorated by the hard-fought passage of healthcare reform, the Obama administration has now set its sights on reining in the power of big Wall Street banks to wreak havoc on the broader economy.  The details of the changes remain murky, and so do the relative winners and losers in the financial community.  One loser might be New York relative to other world financial centers.  New York City’s mid-1070s fiscal crisis was among the triggers of a multi-year depreciation of the dollar to then record lows of DEM 1.70 and JPY 176.

Currency markets have so far not reacted directly to the progress of financial market reform in the Congress.  If anything, the seemingly strengthened White House has been a positive background factor.  The main dollar support, other than being the euro’s natural rival, continues to be the stronger-than-anticipated revival of economic growth.  True, much of the impetus came from inventories, macroeconomic stimulus, and better asset markets.  These supports were recognized in advance, and the bottom line of gross domestic product has easily exceeded consensus expectations since the second half of last year.  The U.S. business cycle has been neither L-shaped nor U-shaped but rather a classic “V.”  Pundits have upped their forecasts of first-quarter growth due next week and some are postulating a 4-handle on 2010 as a whole. A policy report yesterday from the Bank of Canada assumed U.S. growth of 10.4% over the three years to 2011 compared to GDP advances of 5.4% in the euro area and 6.5% in Japan over that three-year period.  The FOMC’s statement next week may produce more rhetorical flexibility to start raising rates either late this year or early next.

The recoveries in the euro area and Japan are broadening, too.  Euroland’s manufacturing and service purchasing manager indices are at 46- and 30-month highs.  The latest Japanese all-industry index was 4.1% higher than a year earlier, and real customs exports were 43.7% greater in the first quarter of 2010 than in 1Q09.  Comparatively strong U.S. growth does not correlate well with dollar movements in the long run but can serve as a pretext now to hold U.S. currency when doubts are bouncing around about the long-term viability of a European currency.  The dollar benefits from a “TINA” argument — there is no alternative.

Commodity-sensitive currencies as a group, which offer a bet that global growth remains solid, outperformed the yen and European currencies this past week, but the Canadian dollar clearly out-shined its Australian counterpart.  That pattern may run further.  Central banks in the two countries sent vastly different signals.  Governor Stevens of the Reserve Bank of Australia signaled the rise of rates for normalization purposes is pretty much completed and that the timing further tightening from here will hinge on evidence of inflation.  Australia’s Official Cash Rate has been lifted five times from 3.0% to 4.25% already, whereas Canada’s central bank target of 0.25% remains at its historic low.  However, Canadian monetary officials strongly hinted that its target would be raised in early June by removing a previous conditional commitment not to begin tightening before at least 3Q10.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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