Lessons from an Eventful Week

October 28, 2011

In the final week of October, Euroland leaders at least managed to agree on something, but the substance of the agreement left virtually all analysts still very concerned about the region.  A significantly stronger U.S. growth rate in 3Q than the first half was meanwhile confirmed.  Quantitative easing by the Bank of Japan was expanded, and several other central banks erred on the dovish side in released statements.  Share prices rallied strongly, and the dollar fell.  Relative to their October lows against the dollar, the Australian and New Zealand dollars have advanced 13.7% and 9.5%.  The Swissie, euro, and loonie have recovered 8.0%, 7.7% and 7.1%.  Sterling is 5.5% higher, and the yen, which hit a record peak of 75.64 per dollar yesterday, is up by 2.3%.  U.S. and European bond yields rose, and peripheral bond yield differentials in the euro area remained painfully wide.  A number of lessons from the week come to mind. Here are ten.

Number one, European leaders have very low credibility.  Close to if not a whole majority of analysts thought Wednesday’s summit would fail to deliver any agreement.  When one did emerge, pundits found more fault than progress with what emerged, and the ever-present lack of detail created a glass half-empty tone to the barrage of assessments.

Number two, a disconnection exists between how markets react immediately to euro debt “deals” and what analysts say about them.  Time and again including this week, markets rally on any plan even if the experts say it fails to address the root problems sufficiently.

Number three, even when markets take a more sober view of events and prospects, the euro remains stronger than what one would expect from a currency in a struggle for survival.  At $1.4159, the euro is very near its year-to-date mean of $1.4032 and some 7% above its average level in 2010 of $1.3258.

Number four, several other key currency pairs are also close to their 2011 average readings.  Swissie/dollar is 1.4% above its mean.  Sterling is 7 pips and less than 0.1% below its 2011 mean.  The loonie is hovering near parity and 1.2% softer than its year-to-date mean.   The yen and Australian dollar are 5.8% and 5.2% stronger than their’s.  It’s been a volatile year but not one with great directional purpose.

Number five, one can draw two inferences from the lack of sustained dollar appreciation.  First, this says more about the dollar than the euro.  Euroland has genuine and very serious short-term and long-term economic and political problems.  However, the burden of proof is on the dollar, not the euro, because the dollar as reserve asset hegemon has more to lose than the euro as its main legitimate rival for that role.  The dollar has an established track record of depreciation going back forty years and is a continuing victim of diversification.  The other inferential explanation is simply that in times of great uncertainty such as these, it should not be surprising for markets to run around a lot without an enduring commitment to one particular direction.

Number six, the Swiss policy of defending a ceiling for its currency against the euro nears its second month operation continues to be successful as the end of its second month approaches.  Since September 7, the franc has ranged between 1.2013 and 1.2074 per euro, and the common European currency hasn’t been weaker than CHF 1.2100 since September 20.

Number seven, yen strength persists in spite of weak growth, very low interest rates, enormous fiscal problems and revolving political leadership in Japan. The elevated yen was one of the factors cited when the Bank of Japan expanded quantitative easing this past week.  In inflation-adjusted terms, the yen appears not to be overvalued, however.  Chronic deflation, that is secularly falling prices, boosts competitiveness even against economies where inflation is contained and low but positive.  The yen’s other source of fundamental strength is its chronic current account surplus.  The United States runs a chronic deficit, in contrast, and the euro area’s current account has shifted from slight surplus to slight deficit.

Number eight, Britain’s decision to opt out of the common European currency looks increasingly brilliant with each passing day.  It was a sensible decision in light of the U.K. history when participating in fixed or semi-fixed exchange rate regimes.  Britain abandoned the gold standard relatively early in the 1930s and suffered a milder economic downturn than the United States.  Sterling’s 14.3% devaluation in 1967 was an early sign of strains in the initial post-war international monetary system.  On June 23, 1972, the U.K. withdrew from the EC Snake, an arrangement of limited fluctuation among some European nations, after fewer than eight weeks of participation because of heavy speculative selling of pounds.  A more recent and widely remembered failure to fix the pound was its exodus from the EU Exchange Rate Mechanism in mid-September 1992.  With an independently floating currency and its own control over domestic monetary policy, Britain now has lower long-term interest rates than euro members with smaller debt and deficit problems.  While undergoing severe fiscal austerity and with higher inflation than Continental Europe, Britain at least has a looser monetary policy than the ECB is delivering.  And sterling seems comfortable around $1.60.

Number nine, analysts aren’t convinced that stronger U.S. growth in the second half of 2011 than the first half will endure.   No less an authority than the Bank of Canada warned this week of an increasing probability of a U.S. recession in 2012 on top of a likely brief euro area recession. 

And tenth, commodity-sensitive currencies continue to perform well.  From their lows in 2008, the Canadian, Australian and New Zealand dollars show net advances of 24.0%, 77.6%, and 57.4%.  Gold is some 143% stronger than its November 2008 low.

The interest rate policy meetings next week at the Federal Reserve and the European Central Bank will provide a theme to trading in the first week of November.  Fed officials have not discouraged market speculation that some new stimulus will be announced.  Even if the ECB were not meeting at a momentous time for the euro, Thursday’s press conference would be attracting considerable attention, since it will be the first run by incoming President Draghi.  Draghi, an MIT-educated economist, had previously been President of the Bank of Italy and thus a member of the ECB Governing Council.  His extensive paper trail of actions and comments is decidedly hawkish on the primacy of price stability.  Market participants fear those are the wrong credentials for contemporary times and are hoping for a more flexible central bank and a better working relationship between it and the fiscal authorities of the 17 member nations that share the euro.  Those hopes are unlikely to be realized, but this first press conference will be an ideal opportunity to signal any modifications as a new ECB chapter begins.  Central bank policy boards are also meeting next week in the Czech Republic, Romania and Australia. 

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

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