Beware of August

July 30, 2010

The upcoming third anniversary of the financial crisis finds advanced economies deeper in debt, struggling to maintain traction, and without a consensus over policy priorities.  Confusion also exists over the next direction of major currencies.  The dollar lost value against most currencies during July in a pattern that persisted into the final days of the month.  Each week of July saw the euro touch higher lows and higher highs against the U.S. currency than the week before.  Dollar bulls haven’t thrown in the towel (see my July 28 article on the euro) but are not predicting as much appreciation as they did earlier.  August can be a tricky month because many dealers take extended holidays.  August can also be a fateful month.  Both world wars started in August (well, September 1 is almost August).  Iraq invaded Kuwait in on August 2, 1990, and former President Nixon severed the dollar’s link to gold in mid-August 1971.  Several intra-European currency crises began at this time of year, and August has seen important and unexpected dollar reversals such as one in 1981.

World financial markets became discernibly less jittery this past month.  Big equity market losses in June in North America, Europe, and even Japan were partly reversed.  Long-term sovereign bond yields were generally steady, unlike in June when several countries experienced sharp declines.  Even though stress tests on European banks had more methodological shortcomings than similar tests on U.S. banks in early 2009, the immediate impact on investor psychology was again favorable.  Economic data released during July brought more pleasant surprises in Europe than in North America or Japan.  All three regions face fragile and uneven recovery prospects.  Investors cannot be terribly confident in ruling out a fresh deterioration of financial market conditions or a relapse into recession.  Much hope rests tenuously on a trickle up effect from dynamic emerging economies like China, India, Singapore and Brazil.

Although second-quarter U.S. growth of 2.4% was almost spot on analyst expectations, the details and benchmark revisions are sobering.  Real GDP expanded just 0.5% per annum in the four years between the second quarters of 2006 and 2010.  Real consumer spending last quarter was at essentially the same level as three years earlier in 2Q07.  A 2.78 percentage point drag from net exports on second-quarter GDP growth far exceeded expectations and suggests that the dollar’s 11% trade-weighted rise between mid-November 2009 and early June this year carries a bigger price than America can afford.  The data also point out that the large budget deficit, which has prompted a voter backlash against doing any more stimulus, was caused by the recession, not reckless fiscal stimulus.  Government expenditures only rose 0.7% between 2Q09 and 2Q10, down from growth of 2.5% per annum over the previous two years.  The pockets of recent strength in the U.S. economy of residential and non-residential investment do not look sustainable.  Incentives, which have been removed, distorted the former.  A 5.2% on-year rise of non-residential business spending still leaves such roughly 12% shy of its level in 2Q07, and the lack of employment growth suggests that the strength in this component of demand will be limited.

Japanese data in the past month point to a weaker pace of recovery after midyear.  Unemployment has climbed to a seven-month high.  During the second quarter of this year, real household spending fell 8.2% at an annualized rate last quarter, and both total and core deflation intensified.  Industrial production in June was nearly 2% weaker than assumed.  After climbing near to a four-year high, Japan’s manufacturing purchasing managers index dropped 1.9 points between May and July, with indications of slower expansion rates in both production and orders.  Export volumes on a customs basis slowed to an on-year 27.4% pace of growth in June from 31.9% in May, 39.5% in April, and 43.7% in the first quarter.  In elections on July 11th, the government lost control its upper house majority, suggesting that legislation will be more grid-locked than ever in the autumn.

The region associated with the greatest investor anxiety during the first half of 2010, Europe, generated the most hopeful economic data during July.  PMI readings for June slid much less in the euro area than in the United States, and the preliminary estimate for the July index revealed an unexpected rise to a three-month high.  Industrial production in the common currency bloc sequentially advanced by 1.8% in March and 0.9% in both April and May, and industrial orders soared 3.8% in May and by 22.7% from a year earlier.  British GDP expanded over 4.0% at an annualized rate last quarter, more than 1.5 percentage points faster than U.S. GDP, but of course that spike is not indicative of the future.  Britain will be coping with the severest near-term does of fiscal restraint and will be a good test case for whether any advanced economies can handle such medicine.  If the austerity pushes the U.K. back into recession as an ill-timed Japanese sales tax hike did in 1997, both the labor market and public finance will deteriorate.  Fiscal cuts, such as those in the U.S. in the early 1990s, tend to be associated with trends of softening currencies.

Commodity currencies advanced against the dollar in July.  The New Zealand and Australian dollars outperformed the Canadian dollar. The affectionately know loonie has teasingly traded almost exclusively between 1.10 per USD and parity for the past year.  At 1.03, it is near yet so elusively far from that psychologically important level.  Moreover, Canada is very sensitive to what’s happening in the U.S. economy and did not itself experience net growth between March and May.  Sentiment toward the down-under economies, by contrast, benefits from Asia’s decoupled and rapid development.

Grinding upward pressure on the yen poses a threat to Japan, whose economy as noted above has run into some rougher waters.  Japan already had very low interest rates when the financial crisis began, so there was less room to cut interest rates.  As rate spreads narrowed, the yen drew strength.  There is a limit to how far it will rise, even though upward movement has been exceedingly slow and thus orderly.  Given Japan’s highly fluid political situation, it should not be assumed that just because officials have eschewed intervention since March 2004, they will continue to let markets decide the yen’s fate. 

In the table below, average values of EUR/USD, dollar/yen and euro/yen are shown for the entire time since the common European currency was created at the start of 1999, for the first five years of that period and for the subsequent 5 years and 7 months.  The table has several coincidences.  The average value of the euro over the entire period is very close to its starting quote of $1.1720.  The mean euro value since end-2004 is not far from its present level against the dollar, and the average for the initial five years was pretty close to parity.  Not long ago, people were predicting that the euro might hit parity later this year, but those forecasts have been withdrawn.  The most interesting message illustrated in the table is the greater volatility exhibited in the dollar’s relationship to the euro than in its value against the yen.

Averages Since 1999 1999-2004 Post-2004
EUR/USD 1.1842 1.0346 1.3444
EUR/JPY 130.38 118.90 142.70
USD/JPY 111.06 115.40 106.40

The Swiss franc advanced more sharply against the dollar between end-May and end-July than either sterling or the euro.  In the franc’s case, unlike Japan’s, intervention is a sporadic reality already rather than a hypothetical possibility.  Swiss officials have been flexible, creating two-side risk with unpredictable and changing tactics and remarks that shift their emphasis.   So long as deflation is kept at bay and insofar as investors expect the Swiss economy to expand faster than the euro area’s expansion rates this year and in 2011, the franc ought to hold its own against other European currencies and perhaps pick up more ground.

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

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