Debt Problems and the Currencies

July 29, 2011

Currency markets have always spent a lot of time waiting for things to happen.  Like a dog with a bone, markets focus on little else until potential game-changing events move from the future into the past, and then they search for a new obsession.  The results at times are less important than removal of a big uncertainty.  The U.S. debt ceiling talks are one of the juiciest bones to come along especially given the broader context of other governments also grappling clumsily with debt hangovers from the Great Recession and previous years of failing to address long-term structural problems.

The U.S. debt showdown is generating enormous risk aversion, which ordinarily supports the dollar, Swiss franc and yen.  While the Japanese and Swiss currencies are trading around record peaks, the dollar has not performed well. Investors have scaled back expectations and are convinced that, no matter what Washington officials do, credit rating agencies have seen enough inaction and will either place the U.S. sovereign rating on review or downgrade it.  From July highs, the dollar at 15:00 GMT today had depreciated by 7.7% against the Swissy, 7.3% and 4.3% against the New Zealand and Australian dollars, 5.5% against the yen, 3.9% versus sterling, and 2.3% relative to the Canadian dollar.  Losses just this week against the Swiss and Japanese currencies amounted to 3.9% and 1.8%.

The U.S. debt crisis has been framed by analysts and investors around the political stalemate that is real and in everyone’s face day after day.  The markets wonder how close to the August 2 deadline will officials delay making a deal, and the possibility of no deal until closer to mid-August emerged this week.  Expectations have been lowered regarding the composition of an agreement and how much time it will buy before the next fabricated crisis surfaces as has occurred time and again in the euro area. 

But a less discussed dimension of the problem is now pushing its way into the spotlight, and this concerns the tolerance of the advanced economies against fiscal and monetary restraint.  Sufficient deficit reduction might not be possible under either an all-partisan Democrat plan or an all-partisan Tea Party plan.  These strategies need adequate economic growth to succeed, but the U.S. economy is more crippled than generally realized.

  • Real GDP expanded just 0.8% annualized in the first half of 2011 when the bulk of QE2 was provided.  A year ago, the FOMC was forecasting a real GDP growth range in 2011 of 3.5-4.2%, and private-sector projections were centered somewhat above 3.0%.  The optimism of these estimates highlights that the economy’s usual resilience isn’t as strong as such was.
  • U.S. real GDP expanded only 1.6% in the year between 2Q10 and 2Q11 and managed only a 0.2% annualized pace during the four years between the second quarter of 2007 (just before the financial crisis began) and the second quarter of this year
  • Anemic U.S. growth is part of a fairly universal phenomenon among advanced economies.  Japan’s “lost decade” between 1Q91 and 1Q01 saw real GDP there climb at a 1.1% annualized rate.  In the ensuing decade between 1Q01 and 1Q11, real GDP rose even more slowly, 0.5% per annum.  The 20-year growth rate between 1Q91 and 1Q11 was 0.8% per annum.  In Britain where a Conservative-led government has begun massive fiscal restraint, real GDP rose less than 1.5% annualized in the first half of 2011 and 0.7% over the four quarters between 2Q10 and 2Q11.  Growth since the onset of the global financial crisis four years ago has averaged negative 0.4% per year in Britain.  Euroland GDP rose by a decent 2.5% over the latest four reported quarters to 1Q11, but the distribution of results among members was highly diverse and included a drop in Greek output of 4.8%.  Moreover, euro area GDP during the past four years averaged just 0.1% per year.

I take away three lessons from Japan’s experience.  First, the hangover from a financial system can endure more than a generation.  Second, the bigger one is, the harder one can fall, and third, reining in public debt requires more than a will to act.  One needs an economy that is sufficiently repaired to tolerate austerity.  Otherwise, macroeconomic restraint just digs a deeper hole.  The Bank of Japan has wanted to normalize rates for fifteen years but is still stymied against doing so, and Finance Ministry officials were looking for an exit strategy when debt was approaching 100% of GDP and are still waiting for the right opportunity as debt hovers near 200% of GDP now.

The U.K. experience offers more warnings to be heeded.  British July purchasing manager survey results will be published next week, but recent trends through June portray a difficult time coping with fiscal austerity.  The manufacturing PMI fell from 61.5 in January to 51.3 in May, while the service-sector reading declined from 57.1 at the end of the first quarter to 53.9 in June.  Slow growth hampers public-sector revenues, and  Britain’s budget deficit was no smaller in the first quarter of the current fiscal year than it had been in the first quarter of the previous financial year.

Economic circumstances in the euro area’s peripheral nations have been very difficult as well.  Market players love to mock the “clowns” who decide policy in Europe and America but fail to fully comprehend that in representative democracies, policymakers tend to be sounding boards of viewpoints found in the rank and file citizenry, only they hold such positions more extremely.  Excessive household and corporate debt tend to be a pre-existing condition for excessive government debt, and Keynesian economic theory suggests that it’s best that balance sheet reductions not be undertaken on a massive scale simultaneously in all three areas. 

Another lesson for the United States from Europe is that whatever is done to cauterize the debt problem proves insufficient in the eyes of market players, who pass judgement with their money.  To be sure, euro zone leaders have offered up a series of packages that treat symptoms rather than causes of the region’s fiscal mess.  It has been said that if half of the concessions made eventually had been taken early in the crisis, market order would have been restored, meaning reduced peripheral bond yield spreads.  I suspect not and believe also that nothing the Congress and Obama Administration undertake in the next week or two will manage to correct America’s structural problems or satisfy investors for more than a transitory while. 

If a deal is fashioned and the dollar responds favorably to the news, I would look for opportunities to shorten dollar exposures, but care should be taken to let any initial dollar bounce play out.  One wrinkle is the possibility of Japanese intervention, which may be deployed when a U.S. deal is announced to engage technical yen selling and lend new impetus to any instant dollar reaction to the news. 

The big force is reserve asset diversification over the medium term.  This should keep the dollar on offer against the key traded currencies and also many emerging market monies.

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


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