Preoccupation with Fiscal Problems

July 15, 2011

Risk aversion remains pervasive.  It would take an unexpected development of huge importance to pull the currency market’s attention away from the deficit/debt problems of the United States and Europe, yet neither of these situations is likely to be discernibly more resolved than now when next week ends on July 22nd.  The U.S. debt ceiling deadline will be still eleven days away at that time.  Investors are unlikely to find great reassurance from the European stress test results.  True, only eight of ninety tested banks failed — five in Spain, two in Greece, one in Austria but none in Germany, Britain, Italy, Portugal or Ireland.  The threshold for passing, a capital ratio of at least 5% over two years of simulated stress for tier one assets, was exceeded by less than a percentage point in the case of sixteen other banks.  Moreover, credibility is very scant regarding government fiscal promises and reassurances regarding the vulnerability of financial institutions when one or more countries default in the region.  Trust-but-verify thinking has been discarded in favor of “seeing-is-believing,” and the depth of lost hope is seen in painfully high peripheral interest rates.

Global risk aversion is best seen in the fixed income markets of the advanced economies, where the long-term trend of ten-year yields hasn’t turned despite elevated commodity prices and robust demand in emerging market economies.  The table below shows the sequential drop of average 10-year sovereign debt yields in the United States, Japan, Germany and Great Britain running from the 1990s through to the early naughties, the Great Recession, the period of policy-induced recovery and this year’s breakdown of the political process in these advanced democracies.  All figures represent period averages.

10Y yields U.S Japan Germany Britain
1990s 6.65% 3.85% 6.58% 7.95%
2000-07 4.70% 1.46% 4.29% 4.79%
2008-09 3.45% 1.42% 3.64% 4.05%
2010 3.19% 1.18% 2.78% 3.52%
1H11 3.31% 1.22% 3.15% 3.53%
July-1H 3.03% 1.14% 2.85% 3.21%
July 15 2.94% 1.09% 2.70% 3.08%

U.S. rates are low due to safe-haven inflows into Treasuries.  Low German yields reflect a belief that only the timing is in doubt about an eventual break-up of the European Monetary Union.  British yields are nearly 1.5 percentage points lower than on-year inflation and in spite of enormous fiscal imbalances that have prompted budget cuts that will test the U.K. recovery’s tolerance for shock.  Very low long-term rates in all of these economies reflect fear that the euro debt crisis could revive the global financial crisis like a monster storm that rotates back on itself. 

A different anxiety relates to Japan’s experience.  Central bank rates there have not exceeded 0.5% since September 1995 not as a result of policy design but because Japan’s economy became addicted to ultra-low rates and can no longer tolerate even very modest tightening.  Despite low confidence with the status quo, distrust also extends to those people claiming that low interest rates do more harm than good and urging governments to normalize monetary and fiscal policies and wait out the bad weather.  In the wake of the Great Depression, it took a massive world war, not time, to cement recovery, and nothing like that lies on the horizon this time. 

Risk aversion has not lifted the dollar as anticipated six months ago, but it is preventing a faster pace of depreciation.  The biggest dollar move against a major currency this year has been a drop of around 12.5% against the Swiss franc.  The franc isn’t tainted by euro or NATO membership.  Swiss traditions of conservative monetary policy, fiscal frugality, low and stable inflation, bank secrecy, and a sound balance of payments have made the franc a favorite currency to hold in times of elevated uncertainty.  The dollar’s worst performance in the second week of July was also at the hands of the franc, a drop of some 2.5% as of 16:15 GMT today. 

The next largest loss was against the yen, calling to mind the Japanese currency’s big gains during the early days global financial crisis.  Dollar/yen averaged 120.32 over the first eight months of 2007 but 14.8% less at 102.57 in March-May of 2008.  The dollar fell about 2% against the yen this past week but is less than 4% softer than its end-2010 level because Japanese officials have counter-punched the market when their currency strengthens beyond 80 per dollar.  They are now doing so again but so far only in a verbal way. Many a dollar trend reversal has occurred during the summer doldrums, and the present time would seem opportune for Japanese authorities to escalate actions to soften the yen.

The dollar has also lost ground in 2011 against many emerging market currencies.  The Korean won, Brazilian real, Russian rouble, and Indonesian rupiah also show year-to-date advances of at least 7% against the U.S. currency.  Against the yuan, however, which is subject to manipulation by Beijing officials in deed if not word, the dollar has fallen just 1.9%. 

The euro has been volatile, sensitive to every development in the peripheral debt crisis and lately softer on balance, which is understandable in light of a significant loss of economic momentum between the start and end of this year’s spring quarter.  (In a week of comparatively few meaningful data releases, the preliminary Euroland and Chinese July PMI readings should draw a market reaction.)  The dollar rose somewhat against the euro this past week but at 15:15 GMT was down 5.5% year-to-date.  That drop was similar to losses of 4.4% against the Canadian dollar, 3.7% versus the yen, 4.0% against the Aussie dollar, and 3.3% vis-a-vis sterling.  The strength of precious metal prices with yet another record peak set this week in gold is also something more likely to happen in a weak dollar market than a weak euro market.

The biggest currency market surprise so far of 2011 is not a death march for the euro but the heaviness of the dollar.  The highly risk averse global environment is serving up batting practice, and the dollar can only hit ground balls back to the pitcher.  U.S. productivity excels, and American firms like Facebook and Apple have been the biggest corporate innovators around.  None of these good vibrations are rubbing off on the dollar, however.  Assuming the culprit is behind-the-scenes diversification, one conclusion is that investors are fed up with the dysfunctionality of U.S. politics both inside the beltway and in grass-roots political movements.  Street scenes in Europe offer a circus, but America’s stumbles constitute a drop from a higher pedestal and a larger challenge to a world economy thinking to the future.

Some will insist that dollar loss is no more complicated than the predictable consequence of the Fed’s much bigger balance sheet.  Officials had little other choice if they were to avert a full-blown depression.  Although some mistakes were made as policy was invented on the fly, the Fed’s actions have not been associated with excessive bank lending, but quite the opposite.  Inflation is actually now slowing almost a year and a half after the end of QE1.  U.S. consumer prices advanced 1.5% annualized between March and June, down from 6.1% in the first quarter and 3.6% in the second half of 2010.  A currency’s movement seldom hinges on any single factor but rather reflects a collage of forces responding to how people perceive the future of the issuing country.

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

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