Currency Markets on a Knife Edge

November 4, 2011

The dollar and other key currency pairs face substantial two-sided risk as the moment of reckoning nears on a number of critical matters involving the euro debt crisis, the U.S. business cycle, and G20 foreign exchange policy coordination.  News headlines will continue to swing the pendulum of risk aversion wildly.  The week of October 28 ended in euphoria when European leaders fashioned an agreement, which although flawed delivered more than expected.  This past week saw risk aversion and uncertainty return with a vengeance.  The dollar in response was showing weekly gains at 14:40 GMT of 4.0% against the kiwi, 3.6% against the Aussie dollar and 2.9 – 3.2% against the loonie, Swissie, euro, and yen.  The pound, by comparison, had dropped 0.9% and traded within narrower boundaries than other currencies during the period.

Global economic momentum will continue to weaken even under the best-imagined scenarios. 

  • A large body of evidence suggests that the euro area relapsed into recession in the current quarter.  The ECB is operating under the presumption that the downturn will be “mild” but acknowledges that risks around its baseline view are skewed significantly to the downward.  Survey data in fact point to a more “severe” event, against which the initial 25-basis point rate cut seems inadequate.
  • The improved pace of U.S. growth during the summer quarter is unlikely to be sustained.  Weakness in home prices, the labor market, household income and foreign demand, plus coming fiscal austerity, point to the return of considerably softer growth no later than the first quarter of 2012.  The Federal Reserve painted a somber picture this week but did not initiate new support.  Any action will affect growth only with a lag, so it’s too late to forestall another soft spot in the business cycle.
  • Japanese September data were mixed, and central bank officials just revised down projected fiscal 2012 growth by 0.7 percentage points to 2.2%.  They look for only 1.5% growth in fiscal 2013, which ends in March 2014.
  • It is mooted that Chinese officials may be poised to shift priorities back toward the promotion of growth and away from containing inflation.  But that has not happened because price pressures linger, and the shuffle will be not nearly as dramatic as made in 2008-9.
  • Although below their peaks, energy prices are creeping upward again and will exert a continuing drag.

Weak growth complicates fiscal consolidation.  In fact, short-term fiscal restraint shouldn’t even be attempted now because it will hurt growth and therefore leave deficit ratios high and debt ratios rising.  Near-term fiscal restraint is being implemented only because politicians in the advanced economies lack the guts to enact budget changes that sharply change long-term revenue and spending paths.  This is the same disastrous approach followed in the 1930s.

Time is running extremely short to avert a catastrophe in Euroland.  Signs of tentative progress in negotiations still elicit sharp, if unsustained, rebounds in financial market health, but investors are losing patience with political leadership, and a danger exists that markets become insensitive to good news from Europe.  The G20 summit in France has thus far failed to fortify IMF resources or hear a finished Greek bailout plan with all t’s crossed and i’s dotted.  A vote of no confidence in Greece would delay rescue efforts possibly beyond the point of no return.  Italy is standing above the abyss as Berlusconi didn’t deliver an austerity plan as promised.  The world economy is being held hostage to the parochial interests of Europe’s nation-states.  In a Utopian world run by enlightened philosopher kings charged with responsibility of delivering the greatest utility to the greatest number, it would be high time to use force if necessary to seize control of Europe and ensure that each country implements what needs to be done now to achieve full political union.  That of course will never happen, so markets are left to contemplate many more malign than benign scenarios for the future evolution of the crisis

It has been reported that the G20 communique will escalate the call for market-determined exchange rates to be allowed more quickly, and China may be singled out by name, something not done in earlier statements from the Group of Twenty.  It would hardly be surprising for the final statement to omit this effort.  The G20 has not proven to be an effective body for effecting needed change and for putting peer pressure on individual governments to take unpopular policy medicine.  The Chinese no doubt are fighting against the new wording and probably have the sympathy of Japanese officials.  China’s critics want a one-shot yuan revaluation on the order of 20% or more.  Since being unpegged from 8.277 per dollar in July 2005, China’s currency has advanced a bit over 30% against the greenback, but that’s an annualized pace of only 4.3%.

It appears that Japanese intervention this past Monday may have exceeded the total of JPY 4.5 trillion done this past August by a sizable margin.  Japan’s Ministry of Finance has now sold yen in very heavy quantities on four separate days, JPY 2.15 trillion in September 2010, JPY 0.69 trillion in mid-March of this year, the aforementioned August 11th operation, and October 31 when the total may have approached JPY 7 trillion.  The September 2010 sales lifted the dollar by 3.6% from JPY 82.88 to JPY 85.92.  In the March operation, the dollar climbed 7.5% from JPY 76.25 to JPY 81.98.  August’s offensive drove the dollar 4.5% higher to 80.24 from 76.25, and this week’s sales of yen bolstered the dollar by 5.5% to 79.53 from 75.35.  It’s been nearly 14 months since Japan took up the forex intervention tool again for the first time since 2004.  On the whole, it’s held the line reasonably well, since the yen is currently just 6% stronger than its value before the first of the four interventions.  Each time they hit the market, the yen weakened substantially right away. If a new G20 statement is perceived to render future Japanese intervention extremely unlikely, Japan’s currency will be apt to draw more speculative demand as an outlet of general risk aversion.

The euro was an awful experiment.  It could have worked if a single fiscal policy had been launched also at the start of 1999, but then political leaders would not have accepted such a bargain.  The best achievement of the single currency has been price stability, but low inflation is a hollow victory if not accompanied by acceptable growth in jobs and GDP.  The past twelve years have demonstrated that internal price stability, that is low inflation, generally transcends to external currency strength.  Faced with possible extinction, the euro is almost 20% stronger than its starting level against the dollar.  With the U.S. currency also pinned neared its historic low against the yen, the euro’s buoyancy says more about investor sentiment toward the direction of the U.S. economy than it does about Europe. 

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

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