Weak Euro Helping Europe and Hurting the United States

July 23, 2010

In disinflationary or deflationary times, it pays to have a depreciating currency.  This lesson was underscored in the Great Depression when Britain went off the gold standard before the United States.  The pound fell, and Britain’s economy faired better than America’s.  The lines of causation between exchange rate changes and economic fundamentals do not only run from the latter to the former.  Both sets of information are determined simultaneously, and sometimes the effects of currency movements on real economic behavior are the most meaningful developments to watch.

So fast-forward to the Great Recession, and compare recent U.S. and euro area economic data.  But first, check out the dollar/euro change associated with the present period.  The dollar benefited at the euro’s expense from panicky risk aversion and concerns about European sovereign debt, climbing 35% from as low as 1.6038 per euro in July 2008 to a high of 1.1878 per euro last month.  A net appreciation of 27.5% against the euro had occurred in the space of just 6-1/2 months to June 2010, one of the steepest dollar moves ever.

A considerable body of crumby U.S. data have been reported during the past month.  Final first-quarter GDP growth was revised to 2.7% from a prior estimate of 3.0% and 3.2% initially.  The manufacturing purchasing managers index declined 3.5 points in June, while non-manufacturing fell by 1.6 points.  The orders components of those reports dropped by 7.2 points and 2.7 points.  Private non-farm employment rose by just 83K in June on top of 33K in May.  Total jobs fell 125K.  The Conference Board measure of consumer confidence plunged almost ten points in June, and the U. of Michigan early indication of consumer sentiment for July fell sharply to an 11-month low.  Total and non-auto retail sales both posted negative changes in May and June.  Weekly chain store data continue to inspire little grounds for hope.  Auto sales fell 4.7%, while pending home sales plummeted 30%.  Consumer credit contracted some three times more than anticipated.  Mortgage applications have not responded as much as one would hope to incredibly low 30-year loan rates.  Housing starts hit a 14-month low.  Existing home sales dropped 5.1%.  The Philly and New York manufacturing indices were much weaker than anticipated, foreshadowing a probable disappointing July PMI reading.  Factory output dropped 0.4% in June, while industrial production edged up just 0.1%.

Recent U.S. data are not only disappointing on their own merit, nor in light of Fed Chairman Bernanke’s prediction of moderate growth ahead in a landscape fraught with an unusual amount of uncertainty.  The data are also awful when compared to the upbeat figures released in Europe.  Preliminary reports covering July have already been released on the purchasing manager indices and consumer sentiment.  Instead of dropping as seemed reasonable in light of the stress test hysteria, the composite PMI reading was 0.7 points higher than in June and at a three-month high of 56.7.  The index was well-balanced between manufacturing (56.5) and services (56.0) and suggests that GDP may growth as strongly in the third quarter as the 2.5-3% annualized pace that is expected in the second quarter.  Germany, in particular, is performing well, as attested further by today’s news that the IFO business climate index recorded its sharpest month-to-month increase since at least 1990.  Consumer confidence meanwhile improved to a score of minus 14.1 in July from minus 17.3 in June.  Industrial orders in May jumped 3.8% on month and 22.7% on year, while industrial production advanced 0.9% (9.4% versus May 2009) after gaining 1.8% in March and 0.9% in April.  Another pleasant shocker today came from non-EMU member Britain, which reported second-quarter real GDP growth of about 4.6% annualized.

The gist of these two sets of economic figures do not jive with the impression of market traders, private analysts, or officials.  Just yesterday, the Bank of Canada released a quarterly Policy Report with new growth assumptions for the United States of 2.9% this year, 3.0% in 2011, and 3.5% in 2012 versus projections for the euro area of 1.0% in 2010, 1.2% in 2011, and 2.3% in 2012.  All 2010, concern has run rampant over the damage that European sovereign debt problems may cause to the region’s banks and the drag that fiscal austerity adopted under duress will impose on regional growth.  Markets are necessarily forward-looking and must assign future risk dangers now, not later.  That behavior can be a game-changer.  So overshooting occurs not only because of the herd instincts of the crowd rushing into or out of a situation but also because the price swings  in the market in turn modify still-unwritten future history.

The final week of July will be an important one for currency markets.  The suspense of not knowing Europe’s stress test results has finally been removed.  Unfortunately, the exercise carries a stigma, having been fudged by the exclusion of banking book portfolios and thus the understatement of exposure to the suspect debt of peripheral euro area member governments if some should default.  Although 92.3% of the 91 tested banks passed, a cloud of doubt remains, and so European markets probably will not react as euphorically as markets did after the U.S. bank stress tests in early 2009.  I suspect the euro, which strengthened briefly beyond $1.30 in both the week of July 16 and that of July 23, will continue to have trouble establishing a beachhead above that level, but the best clue to market’s satisfaction will lie in the changes we see in the high risk premiums that the peripherals are still paying on their debt.

Next week will also be a time to reflect on other currency market circumstances.  Escalating verbal intervention by Japanese officials has slowed the yen’s upward grind perhaps but not stopped it, and the perceived pain threshold for the economy of 85 per dollar is drawing near.  The yen hasn’t had a 90 handle since the week of June 25, an 89 handle since the week of July 2, or an 88 handle this week.  The latest week’s high of 86.35 was not far from 86.26 touched in the prior week and uncomfortably close to 85-something.  Beyond that range looms 84.83 per dollar touched briefly in November 2009, an all-time high of 79.85 in April 1995, and unchartered waters.  The safety margin for waiting and watching the situation is getting squeezed.

If Japanese officials should break the six and quarter year pause in their intervention, they could learn a thing or two from their Swiss counterparts.  Nobody’s three-month market rates are lower than Switzerland’s, not even Japan’s.  The Swiss National Bank puts a premium on the element of unpredictability in its intervention, making sure not to fall into any decipherable patterns.  The franc got as strong as 1.3074 per euro at the start of July but had retreated 4.4% to 1.3681 by July 21 and has a 1.35 handle at this writing.  SNB officials do not talk often about what they are doing or might try.  Japan’s penchant for a constant dialogue with the market should probably be reconsidered by the authorities at the Ministry of Finance and Bank of Japan.

Chinese officials did a bait and switch on the new, more flexible foreign exchange policy that they purportedly introduced last month to assuage U.S. politicians and other G-20 governments.  After only a couple of weeks of appreciation against the dollar, the yuan was flat against the greenback for consecutive weeks and eased 0.1% last week.  Beijing authorities admit that their policy is anchored on a basket of currencies rather than the bilateral relationship with the U.S. dollar, so if the euro recovers further against the dollar, one should not expect as much adjustment of the yuan against the dollar.  This is an exercise in double-speak.  The shift last month was portrayed as a return to the kind of policy that occurred in the three years to July 2008 and seemed to be a pre-emptive gesture for the G-20 and because China’s trade surplus is widening again.  Senator Schumer and other trade hawks in Congress have run out of patience.

Commodity-sensitive currencies like the kiwi, Aussie dollar, and Canadian dollar were the biggest winners this past week.  The odd thing there is that commodities themselves have been more or less trendless of late.  Gold ran out of steam after several invasions of the $1200s, and oil has repeatedly had trouble holding above $80/barrel.  European and Japanese data have been better than expected.  Although U.S. data releases have been full of disappointment, corporate earnings have mostly pleased, and investors expect firms to put all the cash they are holding to some kind of productive use.  Growth estimates for emerging economies including China are robust and backed up by some impressive trends in that part of the world.  The strength of commodity currencies is based on forecasts more than current conditions.  While risks are present, like Britain’s response to the most radical fiscal cuts since Thatcher and perhaps before then, currency traders see the global glass half full, not half empty.

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

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One Response to “Weak Euro Helping Europe and Hurting the United States”

  1. Fernando says:

    A further Euro crisis in Europe is inevitable because for instance Portugal can not continue to run 8%-10% current account deficits with a year GDP increase of 1% or lower , even if you add 2% inflation , this will mean a net increase of at least 5% per year of net external debt on GDP. If one apllies mathematics this will mean a doubling of net external debt every 12 years!…Since as of december , 31 ,2008 the position was already 100% of GDP , Euro zone is conducting Portugal to an unsustainable position, Who will finance net external debt of 200% in next 12 years?!.. and at what cost?!… So something has to Hapen with Euro quickly,otherwise markets will resolve the situation by imploding it and I suspect this will came from a more accute financial crisis..financing suspension altogether for the southern countries….for the time beeing the snowball is still growing starting from very large debt levels!…but there are economic limits for everything!…….Same thoughts might be applied, with necessary adjustments, for the consequences of current account deficits of Spain and Greece.