‘Tis the Season

December 10, 2010

The approach of calendar yearend tends to be a time of reflection on where markets have been and what perhaps lies ahead.  Seven themes will converge on the currency markets in what will be the last week with a semblance of normalcy.  They are seasonal pressures, a possible nascent bear market in bonds, persistent jitters over Europe’s sovereign debt crisis, contrasting policies in the United States and Europe, the consistency of yen strength, an assertive China, and a spate of key data releases and events on next week’s calendar.

The dollar weakens more often than not against Europe’s hegemonic currency in the second half of December, but 2009 was an exception.  In the early years of a floating, market-determined dollar, the German mark advanced against the U.S. currency during late December in 13 of 14 consecutive years from 1974 to 1987, posting an average rise of 1.7% between mid-month and yearend.  Over the first ten years of the euro’s existence, the euro appreciated eight times in this late-December period and recorded an average gain of 1.3% including the two years when the dollar firmed.  For the eleven years in between those examples, the dollar shrugged off this seasonal propensity, rising six times and posting a neutral net dip of 0.1% for all eleven instance.  Last year also demonstrated that the bet on yearend dollar weakness is not a sure thing, as it rose by 1.5% against the euro.  Nonetheless, the history of losses has been prevalent enough to be borne in mind, especially since there is also an historical tendency for the dollar to strengthen in early January.

Many traders and investors are too young to have lived through a bona fide bear market in fixed income securities.  The ten-year Treasury yield began the year at 5.79% and was essentially at that level when the Fed started to raise the fed funds rate a month later.  Over twelve months, the funds rate doubled to 6.0%.  Within a month, the 10-year yield had risen to 6.35%.  After two months such was at 6.92%, and a month after that at 7.10%.  The 10-year Treasury peaked a little above 8.0% in early November 1994, a climb of around 226 basis points in just nine months.  The inflation-adjusted yield almost doubled from about 3.0% at the start of February to about 5.25% in early November, and the dollar traded downward counter-intuitively by about 13% over that period and kept depreciating for several months thereafter. 

Fast-forward to the present, and people are wondering if the rise of the ten-year Treasury yield from 2.46% on September 28 to 3.25% now is the start of the first prolonged bear market in over a decade.   The changed landscape of 1994-95 can be observed in the sequential pattern of calendar year averages from 5.86% in 1993 to 7.06% in 1994 and 6.56% in 1995.  Happening at a time of fiscal restraint in America, it was enough to slow economic growth from 3.6% annualized in the second half of 1994 to 0.9% in the first half of 1995.  By comparison, this year’s to-date average yield of 3.18% is not profoundly different from those of 3.65% in 2008 or 3.24% in 2009.  To be sure, real rates are rising because inflation has slowed, but fiscal policy will be getting very loose again.  So analysts have revised projected growth in 2011 upward rather than down.

The scariest part of the European sovereign debt crisis has been the resemblance it bears to the festering evolution of the subprime loan crisis during the thirteen months from August 2007 until the Lehman failure, which transformed a financial market meltdown into a severe worldwide recession.  Both crises produced a series of flare-ups that bounced from place to place and elicited a policy response customized to the problem at hand.  These local, rather than global, remedies would seem to work at first, but calm wouldn’t last.  The longer the 2007-2008 financial market dysfunctionality lasted, the worse became the market’s premonitions, and the problems snowballed out of control eventually.  Central bank’s as far away from Europe as New Zealand now routinely warn in their outlooks about heightened uncertainty associated with European sovereign debt problems.  One fear is that when, not if, Europe’s disease spreads to the likes of Spain or Italy, the problem will impact the entire global economy.

Rarely has U.S. and European macroeconomic policy been more different.  The Fed puts greater priority on the promotion of growth, while inflation is a rising concern of the ECB and Bank of England.  Every nation in Europe is doing something significant to consolidate fiscal debt.  The only budget constraint happening in America next year will be at the state and municipal level, and it will be swamped by a huge stimulus from the Federal government.  Policy in Washington has taken an about-face in less than six weeks of the election that is completely at variance with the message of the voters.  That’s not to say that more short-term stimulus is prudent insurance.  It is.  Everybody likes a tax cut, so that may mute the people’s anger at government.  But short-term stimulus without any mandated long-term fiscal cutbacks in the same bill courts danger and will undermine the effectiveness of the stimulus by deepening uncertainty and suspicion about the U.S. economy’s multi-year outlook.

Currency markets focus notoriously on short-term considerations.  For years, economist warnings about largely divergent current accounts fell on deaf ears and was ignored by folks who felt that only capital flows matter.  It is not surprising, therefore, that a more worrisome long-run U.S. picture did not prevent the dollar from advancing close to 2% this week against the yen and euro and strongly too against commodity currencies.  Rising interest rates are carrying the day.

The world economy has gone through an extraordinary and still unfolding period of balance sheet repair by banks, households, companies, non-profit organizations and governments since the crisis was ignited in early August 2007 by falling U.S. housing prices, then about a year in progress.  One way to get a sense about what the crisis has done to the dollar is to look at big period averages as done below.

  Dollars per Euro Yen per Dollar
2007: First Half 1.3299 120.10
2007: Second Half 1.4120 115.53
2008 1.4707 103.32
2009 1.3942 93.61
2010 to Date 1.3261 88.00
Today 1.3182 84.03


The euro happens to be trading very near against the dollar to where it was trading in the half year before the onset of financial crisis, having initially strengthened but giving back ground more recently.  The euro’s parabolic flight reveals little about the futureDollar/yen, in contrast, shows a consistent pattern of yen strength from early 2007 until late 2010.  Japanese policy resistance against appreciation, a single-day sale of JPY 2.125 trillion on September 15 against the purchase of $25.6 billion, prevented the yen from scoring a new record high beyond 79.85 per dollar, but the danger of a new up-leg in the yen remains.  Japanese GDP may have contracted in the current quarter, but a drop has to be viewed in the context of an upwardly revised 4.5% annualized advance in 3Q and a climb of 5.3% between 3Q09 and 3Q10.

China has become more assertive in foreign policy with its neighbors and in economic policy with western nations.  China has unacceptably high and rising inflation, while advanced western nations have very low inflation.  An easy policy remedy would be to jack up lending rates and allow much faster appreciation to quell import prices and cool aggregate demand and money growth.  Beijing officials have relied instead mostly on tighter reserve requirements and various forms of administrative guidance.  The yuan dipped 0.1% against the dollar from end-2008 to end-2009 and has so far risen this year by 2.6%, which is less than advances of some 10% by the yen and Swiss franc.  The Chinese resent their colonial past and take great offense at any interfering criticism from other governments.  They are the biggest offshore holder of dollars, giving them the wherewithal to sharply influence major currency relationships through their investing behavior, whether motivated by strictly economic or partly political considerations as well.

Because of the yearend holidays, several indicators are released in December earlier than in other months.  Next week has an influential calendar that includes several Chinese indicators tomorrow, an FOMC meeting on Tuesday, the arrival of U.S. retail sales figures also on Tuesday, the Bank of Japan quarterly Tankan business survey on Wednesday, euro area industrial production on Tuesday, preliminary Euroland purchasing manager readings for December on Thursday, and the German IFO business climate index on Friday.  European growth in the second half of 2010 didn’t slow as much as widely forecast.  The United States shows signs of moving past its soft patch, adding to suspicions that QE2 is mistimed.   Today’s trade data, for example, point to a substantially positive growth contribution from net foreign demand in the final quarter of this year.  After Japan’s upwardly revised third-quarter growth estimate, which surprised many, investors crave more information about the momentum of that economy.  So there will be considerable newsworthy information arriving in the penultimate week before Christmas.

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


Comments are closed.