Chaotic Currency Conditions Likely to Continue

May 21, 2010

The European debt crisis rolls onward.  No enduring solution to the problem exists.  Investors for starters want to see Greece, Portugal, and Spain implement very sharp, multiyear programs of deficit reduction and debt containment but would fear the impact on regional growth and would remain dissatisfied if they got their wish. 

Currencies are only one battleground of recent financial market disorder.  Capital flight in search of safety has clobbered equities and sent bond yields to fresh lows in Germany and to levels not seen except fleetingly in the United States during the past year.  Commodities are down.  The volatility of many markets creates a self-generating momentum.  Whenever one market changes meaningfully, a compulsion develops for other market elements including currencies to adjust.

Market players have to guard against getting whip-sawed.  The dollar is some 21% stronger against the euro than its high reached a half-year ago.  However, this past week up to 16:00 GMT today saw the U.S. currency drop by 1.5% against the European common currency on balance, with the euro leaping 4.3% in one 2-day sequence from a low on Wednesday of $1.2146 to a high today of $1.2673.  For the typical currency market trader where short-term movement is everything, the ultra-choppiness of the price action promotes very difficult conditions, where getting one’s timing right spells the difference between profits and huge losses.  Some of the sharp reversals are engineered by policymakers.  Central bank intervention, which for years was a pretty non-existent factor, is again significant.  The Swiss National Bank returned to the action in March 2009, initially defending 1.50 francs per euro, then 1.43 after mid-December, and recently shifting its target to 1.40.  The Bank of Japan, which habitually only intervenes to cap yen strength, hasn’t admitted doing any operations since March 2004, but government officials can conduct stealth intervention via other channels like through the Kampo Postal Savings service.  The past week has seen numerous rumors of such activity.  Intervention by the Reserve Bank of Australia has been suspected, too.

Investors are pretty sure that this long and winding road will lead to a weaker euro.   The $1.10 per euro level gets mentioned frequently.

  • Euroland officials are not discouraging that conclusion.  They stress that the level of the euro does not concern them at present, only its recent volatility.  Spot EUR/USD is not presently at an extreme but in fact near to both its all-time average and opening levels. 
  • The ECB has squandered some goodwill lately by making a habit of reversing positions.  With their credibility diminished, monetary officials in Frankfurt haven’t convinced investors that the strategy of buying its member’s debt will be fully neutralized with other market operations, so that money and credit growth remain non-inflationary.  One the most important determinants of a currency’s well-being is whether central bank policy is perceived to be appropriate, predictable, and consistent.  The ECB’s usually high marks have suffered considerably.
  • The euro is no longer perceived as a serious challenger to the dominating status of the dollar in reserve asset portfolios.  Diversification into the euro by big holders of reserves like China and OPEC had been a major theme of market chatter last year.
  • The near-term possibility of a euro break-up, however small, requires an added premium to store wealth in that currency.
  • Because of coming fiscal austerity and the inability of Euroland’s weak links to recover competitiveness via currency debasement versus Germany and other stronger links of the currency union, depreciation of the euro against the dollar, yen, and yuan offers one of the easier ways to promote growth.
  • Euroland was growing more slowly than the United States and Japan even before the sovereign debt crisis intensified.  Between the first quarter of 2009 and the first quarter of 2010, real GDP increased 4.6% in Japan, 3.2% in the U.S., but just 1.6% in Germany, one of the euro area’s healthier members.  Personal consumption went up 2.7% in Japan and 1.8% in the United States but fell 1.2% in Germany.  Exports climbed 34.3% in Japan, 10.1% in the United States, and 7.5% in Germany.  Growth disparities moreover widened last quarter, when GDP advanced at annualized rates of 4.9% in Japan, 3.2% in the United States, and 0.6% in Germany.

Commodity-sensitive currencies have faltered sharply since late April.  The Aussie dollar slumped 13.3% from USD 0.9324 on 04/30 to USD 0.8084 earlier today.  The New Zealand kiwi lost 9.6%, dropping from USD 0.7325 to as low as USD 0.6622, and the Canadian loonie declined 7.3% from CAD 0.9969 per USD on April 26 to CAD 1.0750 earlier today.  Like commodities themselves, the currencies of commodity exporters wax and wane with shifting perceptions about global economic growth prospects.  Emerging economies not limited to Asia have recovered much more rapidly than anticipated.  U.S. and Japanese GDP have also surprised on the upside.  Against these positive signs is the mitigating factor of the European debt crisis, and this depressant is not restricted to that region.  The crisis endangers the health of European banks in both the problematic and presumably non-problematic countries.  An infected financial sector, as learned in 2007-9 cannot be quarantined and represents a potentially global systemic risk.

Optimism about the U.S. and Japanese economies will not persist in the face of faltering stock markets and appreciating currencies.  Each is already grappling with a serious structural issue, chronic deflation in Japan and near-10% unemployment and lengthening long-term joblessness in the United States.  Neither is well-positioned to absorb a fresh external shock.  The DOW fell 10% between April 26 and May 20, qualifying as a market correction and half the distance to a bear market.  Today’s better tone of equities based on bargain-hunting means little if there is not discernible progress made as soon as possible in defusing Europe’s problems.  It will be very surprising if U.S. and Japanese equities do not post at least one daily decline of more than 1% next week.  The longer the market turmoil persists, the more harm it will do to the growth prospects of all countries.  One of the biggest surprises of the coming months, I believe, will be how little the G-7 central banks, including the Fed, are able raise interest rates, and the reason will be the vulnerability of asset prices, the elevated level of unemployment, softer growth than experienced recently, and inflation that may run below the comfort zone of officials.

One economy where inflation surprises continue to run persistently to the upside is Britain.  The Bank of England is in no position to raise interest rates in response.  Plenty of fiscal austerity is on the way from the new Conservative-Lib Dem government.  Investors wanted no part of a role for Labour in this government and got that.  Sterling has traded more tightly with the dollar than other currencies, with a 2.2% high-low range this past week compared to the 4.3% range of EUR/USD.  The pound lost 0.7% on balance and remains in the mid-1.40s.

As if investors do not have enough uncertainty on their plate, middle eastern geopolitics seems to be taking an alarming turn.  One would think this should favor the dollar also over the euro, but the ride will be bumpy.

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

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