Dollar Soft in Spite of Risk Aversion

August 22, 2011

The Swissie and yen at 14:40 GMT were 48.8% and 21.2% stronger than their 2010 lows against the dollar and 18.0% and 4.5% above last year’s highs.  The kiwi and Aussie dollar were 3.5% and 1.8% stronger against their U.S. counterpart than at their best 2010 levels, and the U.S. currency was less than one percent from its 2010 lows against sterling and the Canadian dollar.  Even though the greenback is above 2011 lows against all of these currencies, present levels are historically depressed.  The yen set a record high of 75.94 last Friday, and only a half yen separates it from its previous all-time peak.  The euro has not dipped under $1.40 this month in spite of a sharper-than-assumed slowdown in regional growth and particularly in the two most significant members, Greece and France.  The Aussie and New Zealand dollars are pricey with handles above a dollar and 80 cents, respectively.

For much of the four years since the start of the subprime lending crisis, the dollar has traded inversely with the tone of U.S. and global share prices.  Based on that relationship, one would expect the dollar to have rallied more impressively this month.  Two developments differentiate the present from earlier segments of the crisis.

One is the extraordinary and intensifying demand for gold, which trumps the prior pattern between movements in the dollar and stocks.  The value of the yellow metal has historically thrived in times of dollar weakness and lackluster equity prices.  The converse has been true as well.  For example, between August 12, 1982 and January 14, 2000 when the DJIA advanced 16.9% per annum over more than 17 years, gold fell 15.4% or 1.0% per annum.  Until gold corrects downward, it’s difficult to envisage any substantial recovery of the U.S. currency against other paper currencies.  A gain in gold of about 20% over the last month and around 54% over the past 12 months has been caused by a profoundly more negative assessment of the long-term U.S. outlook.

Greater attention to U.S. secular, rather than cyclical, trends is the other anti-dollar development that makes investor reactions in 2011 different from the period right after the collapse of Lehman Brothers.  Between the ends of 1949 and 1999, America experienced at least one recession in each decade and eight downturns in all.  Nonetheless, GDP growth averaged 3.6% per annum in inflation-adjusted terms.  The possibility that the United States may have caught Japan’s disease means that a return to sustained growth of 3.0% may not occur in our lifetime.  Even the 2.5% threshold could prove elusive.  In the ten years to 2Q91 before Japan’s financial crisis and asset bubble meltdown, that country’s real GDP rose 4.6% per annum.  The ensuing 11 years saw only a 0.8% per annum pace of economic growth.  Over in the U.S., real GDP last quarter was still 0.4% lower than its pre-recession high, and growth over the 11 years between 2Q00 and 2Q11 averaged 1.4%, down from growth of 3.4% per annum over the prior decade.  There are other parallels like the downtrend of long-term interest rates in defiance of predictions that mounting fiscal debt would boost rates sharply.

If the United States has indeed slipped into an L-shaped business cycle, the implications for the dollar are substantial.  An economic malaise without escape would constitute as great a change as did the restoration of price stability and the productivity boom that occurred in the Volcker and Greenspan eras.  Currency values embrace the perceived present value of an economy.  Investor expectations about the U.S. economy in 2015, 2020, 2025 or 2050 will need to be trimmed downward in a continuing process of disappointment, until sufficient contrary evidence of either an economic or political nature emerges.  That’s unlikely to happen before the 2012 election.  Right now, the politics is in fact taking a bad situation and making it worse.  Nothing is being done to correct long-term spending and revenue trend, and short-term spending cutbacks will in fact boost outstanding debt and amplify the recession.

It seems beyond reach for the Fed to exceed investor expectations.  QE2 is viewed more negatively than QE1 was a year ago when Bernanke pre-announced the likelihood of a second round of quantitative easing.  Any new gestures from the Fed are likely to be dismissed as a delaying tactic and not change the gloomy long-term prognosis. 

Europe’s problems are actually worse than America’s, but market perceptions of Europe’s economic potential were never as upbeat as those concerning the United States.  At the all-important margin, the United States is the economy with the most to lose in this brave new world, and the dollar should continue to reflect this danger.  That doesn’t mean the euro will necessarily set new 2011 highs.    It does make the forecasts early this year of dollar:euro parity by yearend appear remote and probably contingent on the very unlikely premise of gold relinquishing most of its year-to-date appreciation.  Finally, the main beneficiary of Swiss and Japanese actions to stop demand for their currencies probably will not be the dollar.

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

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