Summer Ending, so What’s Next in Forex?

August 27, 2010

Currency markets have mostly been marking time in late August.  Since my previous Insights essay written two weeks ago, the U.S. currency experienced scant net changes of +0.7% and +0.4% against sterling and the euro, while edging down 0.2% against the kiwi and 0.1% versus the Australian dollar.  The Chinese yuan is unchanged on balance from August 13 and also steady compared to two months ago.  The main two-week movements in the dollar have been losses of 2.1% against the Swiss franc and 1.5% against the yen but a 1.5% appreciation against the Canadian dollar.  Former carry trade liability currencies like the yen and Swissy do well in a risk averse world, since chronically low Japanese and Swiss interest rates no longer drive capital outflows.  Rates are extraordinarily low everywhere, and a strong incentive exists to keep wealth nearby.

Fed Chairman Bernanke’s Jackson Hole address dropped no bombshells.  Fixed income markets had been positions for QE2, a return to quantitative easing.  He didn’t deliver those goods, so long-term rates rose sharply in immediate response but remain extraordinarily low historically.  The instant post-speech response of the dollar and other key currency relationships was comparatively muted.  Bernanke’s somber remarks on U.S. economic conditions and prospects merely stated the obvious after earlier news today that real GDP slowed to a pace of 1.6% last quarter from 3.7% in the first quarter and 5.0% in the inventory-fueled final quarter of 2010.   With the usual disclaimer about the inexactness of forecasting in these highly uncertain times, Bernanke isn’t looking for either a double-dip recession nor price deflation.  Those possibilities would have to escalate to elicit additional monetary relief and then only if Fed officials were confident that the benefits of such steps outweighed potential costs.  That’s hardly the ringing endorsement some traders were anticipating.  Although the chairman’s prepared remarks did not touch on the politically contentious area of fiscal policy, he implied that monetary policy adjustments alone cannot complete the unfinished repair and restoration of the U.S. and global economies.

Bernanke’s baseline forecast is plausible but probably lies closer to the best possible outcome than to the worst one.  His most encouraging observation is that net exports, which exerted a 3.37 percentage point drag on the second-quarter GDP growth rate because of a 32.4% annualized leap in imports, was distorted by temporary factors and should in the future be a much more neutral component of demand.  There’s certainly room for disagreement on that point.   Negative assertions that real GDP growth is too slow, unemployment too high and bank credit still tighter than desired gloss over two problems that look extremely worrisome.

  1. Widely publicized parameters like the 9.5% unemployment rate and unchanged on-year growth in non-farm payroll jobs fail to capture the present dysfunctionality of the American labor market.  In the twenty years between December 1979 and December 1999, jobs advanced 44%, with virtually identical growth in the 1980s and 1990s.  If that pace had persisted, there would currently be 158.3 million workers, about 28 million more than the actual figure.  A gap of such size isn’t going to be eliminated in five years, ten years, or perhaps a whole generation.  Here’s where a breakdown in the ordinary forces of creative destruction are most evident, and a chronically ill labor market will impose a lower speed limit on economic activity for a long time.
  2. The U.S. doesn’t have deflation, that is, generalized falling prices for goods and services.  In the year to July, consumer prices rose 1.2% (0.9% core), and producer prices went up 4.2% (1.5% core).  Import prices advanced 4.9% and by 2.6% for non-fuel items.  In one critical sector, however, consumers are seemingly behaving as if deflation does exist, and that is real estate.  A tendency to delay home purchases because of hopes, or fears, that more price destruction lies immediately ahead has created a self-fulfilling metric.

Risk aversion seems entrenched.  The U.S. Labor Day weekend, which unofficially completes the summer interlude in foreign exchange trading, is just one week away, but the conditions for risk aversion appear solidly in place.  This backdrop entails more than an environment of subdued growth, lower-than-desired inflation, and the possibility that several economies might relapse into new recessions. Equally important is a lack of confidence in the effectiveness of policy remedies that can fix any of the main problems soon.  The financial panic, to use Chairman Bernanke’s expression, started a little more than three years ago.  This afflicted business cycle is already a prolonged affair, and while it might be fair to say we are beyond the end of its beginning phase, it seems even more correct to state that we haven’t entered the beginning of the end-game.  Thankfully, robust emerging economies have outweighed laboring advanced ones to produce decent global growth. 

It remains to be seen whether the developing world invigorates the advanced economies or if the latter group infects the former with a virus of softer growth.  A similar tug of war is playing out in Europe, where it remains unclear  if the strength of Germany and France will trickle down to the other nations or if cause and effect works in reverse.  If that uncertainty were not enough to perpetuate regional uncertainty, harsh fiscal austerity is being dosed out in Britain and Euroland’s peripheral underbelly.

Growth in Japan, now the world’s third largest nation-state economy, seems to have stalled as the second quarter limped to a close.  Officials are deeply worried about the possible future drag of a rising yen and sinking equity prices as I discussed in Now and Yen.  Japan has more fiscal debt than anybody, but the yen is sheltered because such is mostly in domestic hands.  More fiscal stimulus is coming.  Some quantitative monetary easing appears increasingly likely, too, and the possibility of intervention has been planted in the market’s thinking.

The dynamic of risk aversion hits financial markets in waves.  Some days like today see a respite, but the mind-set of risk aversion dominates direction over months.  Among currencies, the yen, Swiss franc, and dollar to a lesser extent are favored.  The euro is presently 4% weaker than its 2010 range midpoint of $1.3230 and much more likely during the next twelve months to challenge the 2010 range floor of $1.1878 than the ceiling of $1.4582.  Commodity-sensitive currencies face headwinds in a risk averse world, even where fundamentals are reasonably decent.  In contrast to the Fed, ECB, Bank of Japan and Bank of England, all of which still have key interest rates pinned at their cyclical lows, the central banks in Australia, New Zealand and Canada have raised interest rates thus far six times, twice and once, respectively.  Nonetheless, repeated recent efforts by the Canadian dollar to break unity failed, and the loonie was the weakest major currency during the past two weeks.  The Aussie and New Zealand dollars continue to hover around ninety and seventy U.S. cents, respectively.  Indeed, their year-to-date average values are USD 0.8923 and NZD 0.7069. 

The week ahead has an extremely heavy data calendar.  It’s also a week in which many traders will be away from their desks for a last fling with summer.

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

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