What Can Markets Do for an Encore?

August 12, 2011

It’s fanciful to dream that uncertainty will disappear and restore the old normal.  Recent times have been distinguished from most times not so much by an abundance of uncertain areas but by the severity of reasonably possible outcomes.  European leaders are in the fight of their lives to preserve the European Monetary System and broader gains from progressive economic integration over the last half century.  Regrettably, no mechanisms were planned at EMU’s inception for guiding policymakers through these minefields, so they must improvise with very high stakes on the line.  Although Britain looks wise not to have participated in the common currency, it is in the U.K. where social frustration turned violent this past week.  The U.S. debt problems ought to be more manageable than those of Europe, except that America’s political system is busted, unable to sift through conflicting interests and produce helpful actions for the majority of people.  Public confidence is shot, as critical problems like unemployment continue to be neglected.  In Japan, already a shadow of its 1970s-80s stature, events this year underscored an unsafe propensity for immense natural and man-made disasters.  Debilitating weather extremes are more prevalent everywhere, spreading fear that the planet may be dying.  Lacking a defined mission, the ten-year war against terrorism marches down the road of forever and, like economic data and climate change, represents another potential bad headline that can occur at any time or place.

It is the job of markets to manage and distribute risk in a cost-effective manner so that business can be transacted and lives improved. Public trust in the market and a willingness to participate in them is just as important as confidence in elected officials and the laws they make and enforce as participants in community life and umpires of private sector disputes.  Confidence in the marketplace has been sorely tested three times since Y2K — first by the bursting of the dot-com bubble, then the housing market depression and credit market crisis, and now the sovereign debt crisis.  Increasingly erratic collective market behavior suggests the build-up of more than a little post-traumatic stress.

This has been a week like no others for equities.  Mounting risk aversion could be observed in increasing average absolute daily point movements of the DJIA from 57 in the first week of July, to 71 points in the next week, 101 points in the week to July 22, 108 points in the week to July 29 and 176 points in the first week of August.  But that crescendo of volatility paled next to the unprecedented 502 average point change over successive sessions on August 8, 9, 10 and 11th with a directional reversal each day. 

The conventional wisdom that the dollar moves inversely with share prices applies predominantly to its relationship with commodity-sensitive currencies and the euro.  With low U.S. interest rates anchored until mid-2013, the dollar becomes even more attractive for financing carry trades that borrow cheap short term funds and invest them in high-yielding other currency denominations. In times of risk aversion, investors favor bonds over stocks and unwind carry trades, a behavior that enhances demand for dollars.  However, the yen and Swissy have even better credentials as financing vehicles for carry trades than does the dollar, so these currencies tend to be well-bid in risk-averse markets.  Waves of risk aversion often lead economic recessions and are therefore associated with falling prices for many commodities, gold being an exception.  At 15:20 GMT today, the yellow metal was 9.3% higher than its value at the close of July 21.  The DOW, S&P 500 and Nasdaq had lost 11.8%, 12.5% and 12.2%, and the ten-year bond yield had plunged by an astounding 76 basis points.  Dollar changes over this interval of 15-3/4 trading days ranged from gains of 5.2%, 5.0% and 4.3% against the Australian, Canadian and New Zealand currencies to declines of 5.5% against the Swissy and 2.1% relative to the yen. 

Sterling and the euro, by comparison, have been islands of stability.  The pound edged up only 0.2% on net in the above period, while the euro advanced 1.1% against the U.S. currency.  Both sterling and the euro are trading near their 2011-to-date means of $1.6170 and $1.4090, and each currency has plenty of own baggage to carry.  Britain is coping with images of street looting and a central bank that, like the Fed, sent out dovish signals this past week.  It will be a long time before the central bank tightens.  One thing for sure, it’s not happening this year as many analysts had presumed until recently and perhaps not in 2012, either.  Along with an extremely accommodative monetary policy, Britain has one of the bigger European sovereign deficits and runs a current account deficit near 2% of GDP.  With debt being the four-letter word that it’s become, currencies associated with sizable twin deficits are liable to face headwinds.

I find it surprising that the euro hasn’t declined more sharply against the dollar.  A tsunami of risk aversion that hit stocks and bond yields normally would be sufficient to weaken EUR/USD back into the 1.30s or even the 1.20s.  During the brunt of the Great Recession, the euro dropped from a peak of $1.6038 in mid-July 2008 to a low of $1.2459 on March 4, 2009, which was just a few days before equity prices bottomed.  Given relentless market pressures now baying at France, Italy and Spain, the euro would appear much more vulnerable than it has been thus far.  Could euro depreciation be the coming encore to follow the stock, bond, and gold theatrics of the past month?

One wrinkle to that inference involves the tough stands being taken to stabilize currencies such as the Swissy and yen.  Swiss officials keep escalating their counter-offensive against excessive franc strength, and a rumor is circulating that they are attempting to fashion a coordinated effort with the ECB to establish a CHF range near 1.15/EUR.  This past Tuesday, the franc peaked at 1.0071 per euro and 0.7066 per dollar.  The yen, which at first obeyed Japanese official preferences more responsively than the franc had done when Swiss officials protested, is now the laggard, and it remains within a half-yen of the March 17 record high of 76.25.  More Japanese intervention seems probable.

Another wrinkle will be the release of several meaningful indicators next week, including the first estimates of second-quarter GDP growth in the euro area, Japan, and Germany, U.S. housing starts, industrial production and various survey measures, British unemployment and retail sales, and Canada’s monthly manufacturing survey.  These important releases have the potential to alleviate or reinvigorate the pessimism that’s driving risk aversion.

A third wild card involves Chinese willingness to appreciate the yuan against the dollar.  The pace amounted to just 3.8% annualized between the end of 2010 and July 21st, but since that day as risk aversion swelled, a much more impressive 14.8% annualized advance has been engineered.  Beijing officials do not manage their currency according to an automatic set-schedule of even-paced movement.  Such waxes and wanes and occasionally even takes a couple of steps backward, so the faster movement over the last three weeks may be just meaningless noise or could signify a welcome decision to engage currency policy more directly in the process of slowing down Chinese aggregate demand and thus containing inflation.  If the Chinese are doing this, they have likely also reviewed other policies like reserve asset diversification.  Profound changes could occur sooner than realized.

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


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