America’s Turn to Face the Music

July 22, 2011

One should resist the temptation to be overly cynical about the new rescue package for Greece.  True, each previous attempt by officials failed eventually to defuse the euro debt crisis and prevent contagion within the monetary union despite initial signs of success in many instances.  Why should this be any different?  This new deal will involve selective defaults, the details of which and acceptability to the ECB remain murky.  Although the plan seems to create enough firepower to protect Greece and other small fry for now, the same may not be true if the crisis shifts to Euroland’s core nations.  For Greece and other vulnerable members, a strategy is still missing for recovering competitiveness and restoring a socially tolerable rate of economic growth. 

Many nations in Euroland would be better off now and in the future if they had never joined the monetary union, but that is not the current choice.  Rather it concerns whether staying in the group looks better than leaving, and EU leaders settled on a plan that answers that question in the affirmative without equivocation.  Last minute agreements are made when common purpose exists among all negotiators to strike a deal.  Europe’s common currency was created in the face of skepticism by market players and economists.  It was fashioned by politicians, who put geopolitical considerations above economic merits, and the game theory metrics haven’t really changed much.  All the negotiators wanted to make a deal and found a way to do it, buying more time for the euro.

In the U.S. debt talks, some factions do not want an agreement to be reached, and that makes the coming week a potentially difficult one for the dollar.  For some, it’s not about getting a good agreement or the best deal possible.  The principles held by each side are considered so fundamental that compromise is unthinkable.  Nobody can say for sure what will transpire for the dollar, long-term U.S. interest rates, and various government fiduciary obligations if the August 2nd deadline is missed.  Such perceived ambiguity is encouraging negotiators to call the other’s bluff.  Maybe somebody will blink.  But perhaps not.  Or maybe, a break in the deadlock will develop but too late to avert lasting damage to U.S. credibility. 

In the month’s leading up to yesterday’s EU deal on Greece, the euro had remained surprisingly steady, averaging $1.400 in March, $1.445 in April, $1.433 in May, $1.438 in June and $1.4184 so far in July.  This tight bunching of sequential monthly mean values masks daily noise that accompanied each new twist and turn in the debt talks.  Still, since April 1, the euro never got stronger than $1.4939 nor weaker than $1.3835.  And at $1.4358 now, this key relationship lies just 0.1% from its $1.4366 average value over the entire period.  Bond yield premiums in Europe have been the pressure point for protest, but foreign exchange has been surprisingly sheltered even when long-term interest rates were in greatest turmoil.

Viewed through an historical lens, $1.4358 is a very strong level for the euro, surprisingly so given Euroland’s political ordeal.  Since being launched at end-1998, the euro has averaged $1.1991 and ranged between $0.8228 and $1.6038.  Over almost four years since the onset of the subprime mortgage crisis on August 8, 2007, the euro has averaged $1.4007.  By further comparison, the euro’s present value translates to a synthetic mark/dollar exchange value of DEM 1.3622 per greenback.  Over the twenty-six years from 1973 through 1998, the dollar had an average value of DEM 2.0525 and ranged between DEM 3.478  and DEM 1.345.  So the euro is also now very near its strongest 1973-98 level in mark terms and has been so since early spring. 

The dollar flourished when the Great Recession was most intense but failed to gain similar traction amid the recent slowdown of global growth.  Britain and the United States will be releasing their first estimates of second-quarter GDP growth next week, and corporations doing business in China are anticipating a slowdown there that exceeds the perception conveyed by recent trends in Chinese demand and production.  Besides the euro, the dollar traded below JPY 80.0 this entire past week, falling as low as 78.21, just two yen from its record trough.  Also this week, the dollar lost about 2% against the New Zealand and Australian dollars and roughly 1% versus sterling.  From its highest levels during 2010, the dollar has lost 35.5% against the kiwi, 30.3% versus the Swiss franc, 25.6% relative to the Aussie dollar, and a similar 17.3% and 17.4% against the euro and yen.  A comparatively small 12.5% drop against the loonie suggests that the loonie may have some catching up to do in the period ahead.  A dip of only 1.1% from the highest dollar value against sterling in 2010 is conspicuous and underscores the similar fate and problems for the U.S. currency and the main reserve currency before the greenback acquired that distinction.

Just one business week remains in July.  Looming beyond that lies August.  These tend to be paradoxical times.  It’s the height of vacation season, a time of thinner market volume and what analysts perennially call the summer doldrums.  But these can also be days of miracle and wonder in the arena of foreign exchange, as a pantheon of historic milestones attest.  The deadline for the U.S. debt ceiling, August 2nd, will be the 21st anniversary of the Iraqi invasion of Kuwait, which triggered a third global oil price shock.  Former President Nixon ended dollar-gold convertibility in August 1971.  The First World War, a cataclysmic event for international finance, began in August 1914, and the Second World War ended in August 1945.  Prior to the euro, August was often a difficult month for intra-European currency relationships.  The world financial crisis began in August 2007, and some of the dollar’s most notable trend corrections in the 1980s and 1990s started at this time of year. 

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

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