A Lack of Confidence in Just about Everything

July 16, 2010

Investors have turned skittish.  One sees this in wildly volatile stock prices – perhaps a sign of the summer season – but also in a sub-0.60% two-year Treasury yield and a 1.10% ten-year JGB yield. 

The resurgence of risk aversion ought to lend the dollar support, but the currency instead experienced a difficult week.  That could change next week as the focus of events and data releases shifts to Europe.  Markets will get details of the bank stress tests and the flash purchasing managers surveys for Germany, France and the entire euro area.  If the dollar remains under the weather in the second half of July, it may be a sign of a different strain of risk aversion.

Currency news all spring had featured a rejuvenated dollar and a forlorn euro.  From a broad 40-year perspective, the dollar had never stopped being depressed.  Even at this year’s highs, the dollar was still weaker than its fixed parities in the late 1960s by 73.6% against the yen, 73.2% against the Swiss franc, and 58.8% against the D-mark translation value of the euro.  When the dollar peaked in early June against the euro, it was still marginally weaker than its all-time average level against the common European currency, and when it briefly touched $1.3008 today, it was 8.7% below last month’s high.  Against the yen, the U.S. currency today came within 1.7% of  the November 2009 trough that also represented the weakest dollar/yen level since 1995.  Outside of the early 1980s and late 1990s, periods of cumulating dollar appreciation have tended to have shorter durations than periods of depreciation.

Numerous headwinds to global growth have either begun to blow or loom ahead. 

  1. U.S. manufacturing is losing steam, and consumer confidence is sputtering.  Factories had spearheaded the year-long U.S. recovery, and consumption figured to be a more significant engine of growth in the second year of  the U.S. expansion. 
  2. China’s economy is cooling off by policy design, but officials are not backing away from restraints on investment and bank lending.  A dip in growth below 8% would be an unintended policy mistake.  These things happen.
  3. European stress tests arrive in six days.  U.S. stress tests in 1Q09 became a growth accelerant, reassuring panicky investors and expediting a transition to positive economic growth.
  4. Europe faces more significant fiscal austerity than Asia or the United States.  True, the brunt of such will not impact until 2011, but the drag is already priced into the thinking of consumers, investors and business managers.
  5. Voters in the United States are strongly opposed to additional deficit spending, but misgivings linger about how or whether the recovery will handle the lapse of such support.
  6. In Japan, where real GDP growth of 4.6% in the year to 1Q10 was more rapid than in any other G-7 country, yen appreciation and a 16% drop in the Nikkei since late April constitute worrisome developments.
  7. New legislation to reform U.S. healthcare and proposals to reform the financial sector introduce new uncertainties into a fragile economy.  They could prove ineffective or do more harm than good.
  8. In spite of very loose monetary policies around the world, deflation persists in Japan and seems more plausible down the road in the euro area and the United States than imagined last winter.
  9. U.S.-Sino tensions over international trade remain high.  A trade war would be in nobody’s interest.
  10. Like fiscal policy, a risk exists that a tightening of monetary policy by several central banks will be imposed prematurely.

The financial crisis that began in 2007 produced a narrowly defined yet very severe plunge in market confidence.  A downturn in U.S. housing prices caused obscure elements of the money market and financial system to seize up one after another, with ever-widening dominos falling both geographically and across sectors of high street and then main street.  The interconnections were not well understood.  Undetectable risks mushroomed in 2008 virtually everywhere, but they were related to the same basic issue.  Risk aversion this time has many dispersed origins.  It’s not just the banking system that’s distrusted.  Neither capitalism nor government seem capable of delivering decent growth in economic output and jobs.  Confidence is low in elected officials, political parties, central bankers, and top-tier companies.  Brand names like Toyota, BP, and Apple have seen their reputations for quality workmanship smeared in 2010.  Whole systems of society like education, medical care, and retirement pensions are overwhelmed by excessive cost burdens.

Among commodity-sensitive currencies, the Canadian dollar was whacked especially hard by risk aversion this past week.  Its weakness and the inability of gold to stay above $1200 per ounce also suggest a new kind of risk aversion.  Canadian GDP and job growth trends had been the best in the Group of Seven, but Canada would be more vulnerable than other commodity exporters if the U.S. recovery stalled.  Gold has performed well when the dollar falters and is a proven hedge in times of extreme shock like the deflationary 1930s and inflationary 1970’s.  Gold seems to have run out of steam during the recent spike of risk aversion, but while dollar was climbing 18% against the euro over the past 12 months, the yellow metal advanced even more sharply (27%).  Usually such trend in opposite directions.

Following the June 19th Chinese announcement of a more flexible yuan, that currency posted gains against the dollar of 0.5% in the first full week and 0.3% in the second week, but it closed unchanged in both the third and fourth weeks.  The currency had been allowed to rise from July 2005 until July 2008, but it then was pegged to the dollar when risk aversion became vey elevated.  This policy is still being defined, but it’s taken a turn that will strain relations between Beijing and Washington and is an ongoing situation to watch.  Another is the yen, which like the dollar has done well when in risk averse times.  The unpopular Democratic Party government now has to share power with the LDP and has little to lose from undertaking a provocative policy change like reintroducing currency market intervention, which was last used in early 2004.

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

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