These are Trying, Confusing and… Yes, Even Interesting Times

March 11, 2011

Recovery from the severest global financial crisis and recession since the 1930s is less than two years old, and many advanced economies continue to experience crippling rates of unemployment that have kept central bank interest rates at historic lows.  A tripling of oil prices from less than $34 per barrel in February 2009 to more than $105 this past week has investors wondering if the recovery’s best days might be already over.  North Africa and the Middle East face unimaginable change.  The ebb and flow of the 16-month-old euro sovereign debt crisis is again intensifying, with yield premiums widening in Greece, Ireland, Portugal, Spain and Italy as officials flounder in their parochial pursuit of an agreement to lighten debt burdens without alienating their own voters.  Partisan politics over budgets is also rampant in the United States at all levels of government. 

Now mother nature is getting into the act.  The Reserve Bank of New Zealand cut its Official Cash Rate this past week by 50 basis points to match an earlier cyclical low of 2.5% to “lesson the economic impact of the Christchurch earthquake last month and guard against the risk of this impact becoming especially severe.”  The kiwi has been the weakest advanced economy currency so far this year, losing 4.8% against the dollar.  New Zealand’s currency is also trading 7% below its early November high and 10% below its 2008 peak. 

The impact of Japan’s strongest earthquake in a century today holds even keener interest for traders. Taking guidance from the aftermath of the Kobe earthquake on January 17, 1995, investors decided quickly that the latest natural disaster favors the yen, which was trading at 98.67 per dollar at the time of the Kobe quake but ran up to an all-time peak of 79.85 on April 19, 1995.  Over those three months, 10-year Japanese government bond yields tumbled by 139 basis points to 3.32%, and the Bank of Japan implemented a 75-basis point rate cut in April to stem upward pressure on the yen.  The rate cut was made in spite of decent economic growth that saw real GDP expand 3.4% annualized in the first quarter of 1995 and 3.2% in 2Q95 when non-residential business investment and public sector spending respectively enhanced the GDP growth rate by 2.7 and 1.5 percentage points.  Although the 8.9 magnitude of today’s temblor exceeds the 7.2 size of the Kobe quake, it hit a comparatively unpopulated area, unlike then, and should not generate comparable rebuilding expenses that stimulate GDP growth.  With the yen currently very elevated already, there’s no way Japanese authorities will permit the yen to soar more than 20% in just three months as happened in early 1995.  The Bank of Japan Policy Board holds a monthly policy meeting next week, providing another convenient opportunity to reassure the public and markets about its determination and means to impose financial market stability as this crisis continues to unfold.

The Fed’s Federal Open Market Committee also holds a meeting and will likely stick closely to the themes struck in Chairman Bernanke’s March 1-2 Humphrey Hawkins semiannual testimony.  Bernanke noted signs emerging of self-sustaining recovery and looks for stronger U.S. economic growth in 2011 than 2010 in spite of continuing high unemployment.  The risk of deflation has diminished greatly, but low inflation and stable longer-term expected inflation are expected to persist.  The chairman believes the spike in commodity prices will “lead to, at most, a temporary and relatively modest increase in inflation,” but a sustained increase in oil prices would obviously be more worrisome.  Investors know that opinion is not monolithic at the Fed but rather spans a spectrum between hawks and doves, which itself is shifting in part because of retirements and new appointments to policy-making committee.  The FOMC meeting next week provides opportunities to shape investor expectations about what the Fed plans in its quantitative easing and about the timing of its first interest rate increase.  The message most likely will be ambiguous in both respects.

The Fed’s unclear message contrasts with the rather precise stance of the ECB signaled earlier this month. Investors like clarity and they prefer central banks that prioritize stability over growth.  On both counts, the euro rose to as high as $1.4037 this past Monday from $1.3857 just before the ECB press conference on March 3 and $1.2907 very early in January.  A clumsy run-up to this week’s meeting of euro area finance ministers and the downgrading of Greek and Spanish debt reversed the momentum of EUR/USD.  The reversal is young and will be susceptible to news that affects risk aversion in general such as the unexpectedly weak Chinese export figures reported this past week, further movement in commodity prices, and how the EU meetings conclude.  Stock prices will be a good barometer to watch, as the inverse correlation of stock prices and the dollar’s euro value is back in vogue.  Equities through 15:40 GMT today had fallen this week by over 4% in Japan, over 2.5% in Europe and around 2% in the United States.  That’s a constructive backdrop for the dollar.

Year-to-date movement in key currency pairs remains relatively limited and inconclusive.  Investors are groping for stronger directional convictions, but it’s hard for that effort to gain traction when trading is based most heavily on negatives like rising oil prices and the fiscal difficulties that so many governments collectively face.  The value of all paper currency is viewed with suspicion.  So are increases of 117%, 95%, and 87% between March 9, 2009 and March 9, 2011 in the S&P 500, Nasdaq and DJIA.  Amidst rising commodity prices and accelerating core inflation in many emerging markets, concerns have grown also about fixed income securities.  A 3.41% yield on 10-year Treasury securities looks awfully low juxtaposed against period averages of 4.71% in 2000-06 and 6.65% in 1990-1999.  Since the August 2007 onset of the financial crisis, gold shows a gain of 109% from $677.50 per ounce, and the yellow metal is up 452.5% from its fixing of $257 on April 10, 2001, an annualized advance of 18.8% over a span of just under a decade.  Maybe that excessive too, but a lot of investors will continue to think otherwise as humans and mother nature continue to do their best to mess things up.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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