Wake Up! …It’s Getting Very Late

November 27, 2011

A dramatic loss of investor appetite for risk occurred in each of the past two weeks.  One sees this in equities, bond yields and currencies.  The Dow Jones Industrials Average fell 2.9% and 4.8% in those sequential weeks.  The Nikkei lost 1.6% in the week of November 18th followed by 2.6% last week, and the German DAX suffered back-to-back declines of 4.% and 5.3%.  U.S. 10-year Treasury yields fell by a combined 10 basis points, while their German bund counterpart jumped 29 basis points.  The Portuguese, Belgian, Italian and Spanish sovereign bond yield spreads vis-a-vis German bunds widened by 132, 97, 52, and 47 basis points over the two weeks, while that of British gilts narrowed by 38 bps to a mere 4 bps. 

Risk aversion favors the dollar and yen, while depressing the commodity-sensitive and European currencies.  The dollar rose against the euro by 1.7% in the penultimate week and then another 2.1% last week.  From November lows, the dollar has climbed 9.6% against the kiwi, 8.9% versus the Australian dollar and 5.2% relative to the Canadian currency.  The greenback on a similar basis closed on November 25 with gains of 4.8% against the euro, 6.1% versus the Swissie, and 4.4% against sterling, but it was 1.1% softer than its November high against the yen.  Chinese officials have full control over movement in their currency.  When an appetite for risk exists, a progressive, albeit slow, rate of appreciation is allowed.  When investors run scared, the yuan shows greater two-sided movement and goes nowhere overall.  In the nearly three months since end-August, the yuan advanced just 0.1% on balance against the dollar.

The window is closing for saving the European Monetary System, and the response of officials to prevent a disaster continues to be minimalist.  “Kicking the can down the street” has been the favorite metaphor over the past year, that is doing just enough to prevent a break-up now but not enough to dissuade investors that a rupture of the system lies ahead sometime.  Solutions are deferred with promised action that prove illusory because of a lack of their implementation.  Ultimately, political leaders never secured an adequate popular mandate for economic union, that is a single fiscal policy and a highly integrated and powerful regional political government. 

Even if the leadership in Europe now consisted of the cast of characters that fashioned a so-called economic and monetary union (EMU)  in the late 1980s and early 1990s, it would still face a nearly impossible task getting popular support for the painful compromises that are required to save the euro.  In any case, the euro cannot and will not be preserved indefinitely using the current German recipe of fiscal austerity, structural reform and minimal concessions from creditors and modifications of demand management in Germany and other surplus economies in the common currency area.  Under that plan, it’s not possible for the peripheral economies to recover competitiveness and dig out from their recessions. 

That’s the “no way out” logic that’s powering risk aversion, but it doesn’t have to be the way things play out.  The economic problems of Europe, the United States, and Japan represent foremost failures of political systems to self-administer unpopular medicine.  Groups that “have” are unwilling to relinquish their advantages, and those that are hurting have nothing else to lose and thus little vested in preserving EMU.  But political metrics constantly change, and one of the worst mistakes investors can make is to assume the impossibility of politically fashioned solutions to disorderly and unsustainable economic and financial circumstances.  This lesson — namely that things will indeed change either by design or the force of market circumstances — was driven home in the dollar doldrums of the 1970s. 

Back then, a chronic U.S. current account deficit and relatively high inflation created increasingly one-way dollar depreciation.  A series of U.S. policy responses ranged from malign neglect to benign neglect or grudging action that was too little and came too late.  It became apparent by 1978, however, that depreciation and domestic inflation were feeding one another in a vicious circle whose dynamic was in fact intensifying.  Depreciation alone had not galvanized public opinion, but worsening inflation did.  And so the Carter Administration acted with a force that had seemed highly improbable, first fashioning an enormous war chest of resources to counter speculation and then appointing Paul Volcker to head the Federal Reserve.  Under him, monetary policy eventually tightened dramatically, and the whole tone of the dollar was transformed in 1980-84.

Right now the dollar’s prospects look hopeful, and the euro’s appear bleak.  But this is just the kind of backdrop when unthinkable policy shifts occasionally occur.

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

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