Risk Aversion, Not Growth Prospects, Again Driving Foreign Exchange

June 25, 2010

Economic growth prospects have discernibly darkened in advanced industrial economies, so financial markets are looking beyond what should be a respectable second quarter.  An interest rate hike by the ECB, Bank of Japan, or even the Fed is nowhere in sight.  The ECB and Bank of Japan have taken liquidity-supporting steps, which at the least constitute a pause in the consideration of policy normalization.  The Fed just added downwardly trending core inflation to its assessment and gave a marginally less upbeat view of economic conditions and prospects.  Blackmailed by market forces, European governments are going to implement simultaneous tightenings of fiscal policy that range from moderate to ruthlessly harsh.  Investors wonder how much near-term negativity will be injected by the Gulf oil spill disaster, U.S. financial market reform, the shake-up of U.S. troop command in Afghanistan, and Beijing efforts to forestall inflation.

Sharp slides in equities and long-term interest rates reflect the more guarded mood and will become an additional cause of future economic weakness.  Since April 26, ten-year sovereign bond yields have dropped by 72 basis points in the United States, 62 bps in Britain, 48 bps in Canada, 45 bps in Germany, and 18 bps in Japan from 1.33% to 1.15%.  The Nasdaq, S&P 500, and Dow Jones Industrial index at 15:00 GMT today were down by 12.4%, 11.8% and 9.9% since that same date.  Japan’s Nikkei had lost 12.8%.  The British Ftse is off 12.3%.  Chinese shares continue to retreat ominously.  Australia’s index had fallen 9.6%.  The German Dax’s 4.5% decline was a conspicuously smaller drop than most other markets incurred.  For Germany, a softer euro is a blessing.

The recession/recovery business cycle was closely associated with the performance of the stock market in the United States.  The DOW peaked in October 2007, two months after the onset of the financial market crisis and only had lost 4.5% in the end of the final quarter of that year.  By mid-2008, the DOW was down 19.9% from peak, however and essentially qualifying as a bear market, and economic growth had slowed from 2.9% annualized in 2H07 to 0.4% annualized in the first half of 2008.  The recession intensified in the second half of 2008, with GDP contracting 4.0% annualized and the DOW slumping 22.7% and more than doubling its cumulative loss.  The DOW would plunge another 25% in the first nine weeks of last year, bring its cumulative decline for the move to 53.4%.  Not by coincidence, the first quarter of 2009 saw GDP slump at its fastest pitch, minus 6.4% annualized.  Labor market weakness was most pronounced that quarter, too, and analysts were predicting a “U” or L-shaped cycle.  The more impressive-than-anticipated rebound to negative 0.7% growth in the second quarter, +2.3% in 3Q09 and +5.6% in 4Q was matched by the DOW, which ended last year at 58% above the March low.  Swings of the stock market with the kind of wide amplitude seen since 2007 cause enormous shifts in national wealth, sufficient to produce big swings in real activity.  And so now, the specter of the Japanese 1991-to-present experience of very volatile but overall minuscule growth and a slip-sliding stock market hangs over the rest of the advanced-economy world.

The dollar benefits from risk aversion.  A correlation between the ebb and flow of risk aversion and the U.S. currency has been observed time and again since 2007.  The pattern makes conceptual sense.  Treasury securities are the safest paper assets on the planet.  Until the euro area survives the present sovereign debt crisis and emerges with better balance among its members and decent overall non-inflationary growth, the dollar will be unchallenged as a favored reserve currency with no close rival.

The yen is also favored in times when investors seek safety over return.  Japan’s chronic current account surplus (3-4% of GDP this year) and very low long- as well as short-term interest rates make Japan a natural exporter of capital most of the time.  However, fewer outflows occur at times like these.  When markets are riled up, it’s sensible to keep wealth nearby where it can be accessed quickly and without any foreign exchange risk considerations.  Japan has huge and unsustainable fiscal problems, and Prime Minister Kan might just offer the final hope for tackling the problem.  Unfortunately, he could be gone in September.  The yen is considerably stronger than when Japan had an enviably strong economy.  It may be a walking time bomb of depreciation, but people have lost money waiting for it to go off.

Chinese officials with some validity believe that excessive yen appreciation was the main reason for Japan’s shocking turn for the worse, and they are determined not to placate foreign meddling and repeat Japan’s error.  A G-20 meeting this weekend is likely to devote much more attention to the euro than the yuan.  Beijing finally lifted the peg to the dollar but in the first week of the new policy also demonstrated that the currency will be moving two steps backward for every three steps forward and on the whole crawling before investors see it walk or run.

The dollar is battling to break through 1.20 per euro.  The euro got has high as $1.5149 in the week of November 27 and came exceedingly close to replicating that feat in the first week of December, but it never closed above $1.50 on a Friday to solidify the graduation to a higher plane.  The euro fell below $1.40 in the final week of January, two months after it peaked, and took just over three months until the first week of May to close below $1.30.  $1.1878 was touched in the second week of June, but there still has not been a Friday close south of $1.20.  Such a move should be only a matter of time.  $1.175-$1.225 is a very neutral band from a long-term perspective, enveloping the euro’s starting point in 1999 and being very close to the relationship’s lifetime mean of $1.1835.  The euro’s engaged in the biggest crisis of its existence and, accordingly, ought to weigh less than its all-time mean value.

While EUR/USD consolidates in the low $1.20s, the common European currency has relinquished ground against its key crosses.  The Swiss franc touched a record high against the euro of 1.3457 earlier today.  That level represents a gain of 14.5% from the franc’s March 2009 low reached after officials began intervening to cap the unit’s strength and resist deflation.  Compared to end July 2008, the franc is about 21.5% stronger against the euro.  Appreciation began anew  in December after Swiss National Bank officials indicated a more flexible currency policy and was further fostered lately when monetary officials said the deflationary threat had almost passed.  That pronouncement is at odds with the Fed’s view that underlying inflation is receding.

Britain has a new Conservative government, which is imposing severe fiscal austerity including a hike in value added tax.  A similar agenda accompanied the election of Maggie Thatcher as Prime Minister on May 3, 1979.  The pound then was trading at $2.0775 and by the election of Ronald Reagan as U.S. president some 18 months later, sterling had appreciated 18% against the dollar and roughly 12.5% against the German mark.  For now, sterling is liked more than the euro.

Commodity currencies are out of favor because of new reservations about future world growth.  The Canadian dollar can’t get to parity with the greenback even though Canada presents the best package of economic fundamentals of any member of the Group of Seven.  Australia’s prime minister resigned unexpectedly, but the Labor Party’s unpopular policy agenda hasn’t changed.  Aussie monetary policy is on hold.  New Zealand’s kiwi did much better than the Canadian and Australian currencies this past week, bouncing off USD 0.70 today to close near USD 0.715.

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

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