Many Governments Want a Weak Currency, But Not All Can Make it Happen

June 18, 2010

The euro experienced its best week in many months but was not alone in advancing against the dollar.  The euro’s gain was pretty much matched by the New Zealand and Australian dollars and surpassed by the Swiss franc.  The U.S. dollar dropped about 2% against the yen and around 1% against the British and Canadian currencies.  Several emerging market currencies like the won also scored impressive gains against the greenback.

The dollar had been benefiting from Europe’s sovereign debt crisis in a direct way but also because the crisis revived risk aversion, which favors Treasury securities.  From 1.5149 per euro in late November to 1.1878 on June 7, the dollar had soared 27.5% against Europe’s common currency in just over a half-year, more than enough to justify a period of consolidation. 

Europe’s problem exposed several flaws.  The euro married currencies with vastly different histories in an arrangement with poorly defined mechanisms for ensuring and enforcing fiscal policy coordination.  As the crisis took shape, regional leaders acted along parochial interests, dismaying investors further.  The status of financial institutions in the region with holdings of sovereign debt became unclear.  Soaring Greek and Spanish bond yields have elevated the urgency attached to fiscal austerity, even though deflationary risks are still lurking.  As in the U.S. housing market crisis, information was hard to get and to verify.  Publishing bank stress test findings will remove some of the opacity, but the situation remains highly uncertain.  Investors want to draw parallels with the U.S. banking crisis, which simmered down greatly after the U.S. bank stress tests, but the situations are not really analogous.  For one thing, Europe’s crisis followed fast on the heels of a deep global recession, so fragilities that did not exist in the summer of 2007 are now omnipresent.

Investors bear some responsibility for the confusion.  Self-righteous market chatter continues that governments with big deficits must slash spending and lift taxes, lest they become the next Greece.  An 80 billion euro austerity package from Germany’s government is one response to this chorus and seemingly will magnify pressure on less frugal EMU members to match the gesture.  The Conservative/Lib-Dem British coalition government is presenting a very restrictive budget on June 22, creating further peer pressure on other countries to shift policy gears.  Prospects for economic recovery in advanced economies carry downside risks that will deepen if everyone tightens at once.

While complaining about sovereign debt, investor behavior is telling a different story with no hint of overheating.  The rally in stocks stumbled.  Ten-year German bund yields are 66 basis points below their April high, 82 basis points lower than a year ago, and 187 bps below where such stood two years ago when the financial crisis had already been festering for about 11 months.  This whiff of deflation is not just limited to Germany.  British gilts have fallen 70 bps in the five months since late January and are 163 bps lower than two years ago.  Ten-year Treasuries are 76 bps lower than their April high, 61 bps lower than a year ago, and 92 bps under their level of two years ago.  The ten-year JGB yield is only 1.21%, 25 bps less than a year ago and down 57 bps from two years ago.  Compared to bond yield averages for the entire decade of the naughties, bunds, Treasuries, gilts and JGBs are weaker now by 143 bps, 123 bps, 111 bps, and 24 bps. Markets challenged governments to shape up or ship out and are now cringing at the possible damage their advice may cause to these economies.  The prospect of fiscal tightening in Europe hand-cuffs ECB maneuverability and is likely to put the euro back on a declining path before long.

The euro combined strange bedfellows.  The Greek drachma, Spanish peseta, Portuguese escudo and Italian lira weren’t holding their value against the German mark.  From the 1960s to end-1998, the drachma depreciated from 7.5 per mark to about 240/DEM, a plunge of roughly 97%.  The lira locked into the euro at a parity that was 73% weaker against the mark than where it traded in December 1974.  The peseta and escudo had already lost considerable value by September 1983 but over the ensuing fifteen years managed to drop 33% and 54% additionally against the mark.  Even the French franc, considered a hard currency by the 1990s, entered the euro some 45% weaker against the mark than where it was trading in late 1974.  Periodic depreciation had been necessary to restore eroded competitiveness in these countries, and that’s now an extraordinarily risky and costly option.  The only recourse will be for the euro itself to lose more ground against other currencies including the Swissy and dollar.

The dollar/yen relationship, 90.77 as of this writing, continues to be very stable.  It posted period averages of 92.51 so far this quarter, 90.73 in 1Q10, 89.86 in 4Q09 and 91.78 over the past twelve months.  Japan has more total debt relative to GDP than any other major economy but the lowest long-term interest rates and downwardly trending consumer prices.  The new prime minister wants to chart a tighter fiscal course and combine such with a very accommodative monetary policy.  That’s usually a recipe for currency depreciation and particularly so from an overvalued level.  In September 1985 at the time of the Plaza Accord when Japan was considered a much healthier economy than now, the yen was trading 62.5% weaker at 242 per dollar USD.  The yen is also almost 45% stronger now than then against the mark.  I expect the new Japanese government to intensify efforts to depreciate the yen and to achieve some measured success in that regard.

In 2005 when Beijing officials uncoupled the 8.277 per dollar ten-year-old peg and began to let the yuan rise against the dollar, investors widely believed the change would lift the yen, too.  That projected lock-step move didn’t happen, and I do not expect a resumption of and upwardly creeping yuan to have that effect on the yen this time, either.  Chinese officials haven’t heeded foreign urging that they let the yuan climb and do not want the topic to be on the G-20 summit agenda, which is scheduled in Toronto for June 26-27. From where Bejing officials sit, one of the top Japanese policy blunders was letting the yen advance excessively.  However, accelerating inflation, excess domestic liquidity, and rapid real economic growth are creating a good domestic case to modify Chinese currency policy.  I expect a shift before yearend and possibly next quarter.

Swiss authorities subordinated domestic monetary policy to an exchange rate policy during most of 2009 but have allowed the franc to climb about 10% against the euro relative to their former target.  Last week’s Swiss National Bank press conference gave markets a further pass to probe the central bank’s greater tolerance for appreciation. Switzerland runs a big current account surplus and has a comparatively insignificant budget deficit.  The franc has an historic association of tracking gold, so it doesn’t hurt the currency’s prospects either that gold set a new all-time high today.  If European growth flounders under the weight of fiscal austerity, the central bank will be prepared to cap the franc.

The fatigued British Labour government had become a sterling drag.  That weight has been lifted, and fresh leadership is inspiring new excitement.  Tuesday’s budget will be a good test of the enthusiasm, and sterling’s response will be an important litmus test of the market’s confidence in what Prime Minister Cameron is trying to achieve.

Commodity currencies were big winners in 2009.  From the year’s lows to subsequent peaks, the New Zealand, Australian and Canadian dollars advanced by 56%, 50% and 28% against the U.S. dollar.  Central banks in all three countries have begun to raise interest rates, but they are at very different stages of the normalizing process.  None of the three currencies shows much net change this year as we approach its mid-point.  A bet on commodity currencies is a bet on global growth.  While forecasters project such at or above 4%, significant downside risks exist.  The failure of commodity currencies to climb further in 2010 is a hedge that based on a belief that growth will turn out to be weaker than thought and risk aversion may stage a revival.

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

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