Significant and Two-Sided Currency Market Risk

January 27, 2012

Since the start of the financial crisis in 2007, analysts have hedged forecasts of growth and inflation with the caveat that extraordinarily high uncertainty creates the potential for outcomes both well above or well below baseline predicted paths.  An analogous truth should hold for key currency pairs over the next month or two.  Investors late last year and in the early part of January wanted badly to believe in a stronger dollar scenario.  U.S. demand and production seemed to be strengthening faster than expected, and Greece and the unfixable euro debt crisis was running out of time to save the shared currency network. 

For a number of possible explanations, the dollar hit an air pocket this month, dropping from its earlier January highs by 5.5% against the kiwi, 4.4% versus the Australian dollar, 4.1% relative to the Swiss franc, 3.8% against the euro, 2.9% versus the loonie, 2.7% against sterling and 1.9% relative to the yen. One factor generally not getting mentioned is adverse seasonals.  The dollar often performs very well in the first half of January but less so later in the month.  A second factor is lessening fear about the imminent failure of European banks in the wake of the ECB’s generous three-year refinancing operation in mid-December.  Another such operation is planned next month.  Prime Minister Monti in Italy has been a huge improvement from his predecessor, Berlusconi, and leaked reports have persuaded investors that a Greek personal sector involvement deal is near completion.  New worries also returned about the United States, first from Fed Chairman Bernanke’s downbeat news conference and then reinforced by the grim composition of the 4Q national income accounts released today.

A number of self-evident observations are knocking on the market’s collective psyche. 

  • First, dollar depreciation is a clear intent of the Federal Reserve’s "highly accommodative" monetary system, and that’s probably more true in the present verbal jawboning stage than earlier when easing took the form of slashing short-term interest rates and then a rapid expansion of the central bank’s balance sheet.  Policy communication works by changing private sector expectations and behavior.  There’s more potential downside scope for the dollar than in either short- or long-term interest rates from current levels.  In addition to making exports and import-competing goods more competitive, a weaker dollar would boost import prices and thereby counter disinflation.  The GDP and core personal consumption deflators rose just 0.4% and 0.7% at an annualized rate last quarter, which is far beneath the Fed’s price stability mandate.


  • Second, advanced economies are all losing the struggle to generate self-sustaining economic recoveries and a return to former long-run trends.  U.S. real GDP advanced 0.6% per annum between 4Q06 and 4Q11, down from 2.8% per annum in the five years to 4Q06 and 3.5% per annum in both of the previous sequential five-year periods.  Japanese GDP contracted 0.4% per annum in the five years to 3Q11, down from 1.5% per annum between 3Q01 and 3Q06 and a 0.3% pace between 3Q96 and 3Q01.  The annualized pace of Euroland GDP slowed from 2.6% per annum in the five years to 3Q01 to 1.6% over the next five years and 0.5% over the most recently reported five years.


  • Third, China is unlikely to step again into the locomotive role it served for the global economy in 2009.  China has severe dislocations of its own such as a property market bubble and inflation that only recently came off the bubble.


  • Fourth, combating economic difficulties is more easily accomplished with good political leadership, which is sadly lacking now.  This can be seen especially in the pattern of Japanese growth, which perked up under Prime Minister Koizumi in the early noughties but floundered both before and after his stewardship.  Europe is a political free-for-all.  No cohesion exists there between countries or involving the region’s major institutions.  The art of compromise is even more important for the political model of shared government used by the United States, but that possibility is poisoned by the lack of personal respect for the other side among politicians and their supporters.


  • Fifth, self-imposed austerity is a lose-lose formula from a starting point with abundant unused productive resources.  This strategy depresses economic growth, which in turn prevents fiscal deficits from falling anywhere nearly as much as assumed, if at all.  This principle holds all the more when all countries attempt fiscal austerity at the same time.


  • Sixth, the potential problems of a common monetary policy for many different sovereign nations in Europe have come home to roost. What wasn’t anticipated by critics of the euro during that experiment’s gestation period is that it would pose an enormous threat to the entire world economy as well as the region directly involved.  Contagion forces if Greece defaults or the euro breaks up more widely are apt to be stronger than after the subprime mortgage market malfunctioned.


  • Seventh, trade protectionism could intensify, adding immensely to already-existing depressants on growth.  One of the bright developments since 2007 is that protectionist barriers have been fewer than feared in this period, but a danger remains because conditions are very fertile for a trade war.  No dimension of trade protection can be more insidious than currency manipulation.  Japanese officials have become increasingly worried that the yen hasn’t backed away from its near record-highs of of 77 per dollar and 100 per euro.  China has always managed the yuan according to what the government felt is best for China, rather than to quell its foreign critics.  But even within China, opinions are no longer monolithic over the optimal currency strategy, so predicting the yuan’s end-2012 value carries considerable imprecision.

Looking forward from here, it’s easy to be quite bearish about the dollar, euro, and yen.  The Fed’s weak dollar agenda is fairly transparent, and a mix of tight fiscal policy and ultra-loose monetary policy would be diametrically opposite to the configuration in the early 1980s when the dollar doubled in value against the mark.  The U.S. currency seems a natural candidate to become the most favored liability currency in carry trades; and remember, the yen stumbled in 2005-06 when it had that distinction.  The U.S. political campaign of 2012 will present very different visions, piling up uncertainty on top of uncertainty, and the undeclared critical issue will be whether anything can be done to stop America’s downshift in world standings.

Europe’s argument over Greece will go many more rounds past the current haggling over a PSI deal.  A Greek default or even exit from the euro is possible, however remote, on any weekend.  Peripheral bond yields remain unmanageably high and will climb further if Greek vibrations fail to simmer down.  The ECB is going to have to ease its monetary policy further to combat the recession.  None of this will be good for the euro.

The Bank of Japan has at least stabilized dollar/yen with its intervention.  I believe 70/$ or even 60/$ would have been challenged if Japanese officials had instead adopted a laissez fair stance instead.  Intervention without complementary support from changing economic fundamentals cannot reverse the trend, but now an important source of underlying yen buoyancy, Japan’s chronic external surpluses, is ending.  A JPY 2.48 trillion customs trade deficit in 2011 was the first calendar year deficit since the second OPEC price shock produced a deficit in 1980.  The deficit this time is grounded in more enduring fundamentals. The current account seems headed for the red, too.

As long as these various currency depressants carry more bark than bite, currency markets may be content to meander along with no big cumulating movement.  But the chances of all the risks staying contained do not seem very likely.  Something big is likely to give way some time during this year.  A big player in the market continues to be China, which observed the Lunar New Year holiday all this week.  Their presence next week will inject a new force.  Another factor coming to the fore is the approaching end of Japan’s fiscal year.  Currency market folklore suggests that the yen should do well in February and March as wealth held abroad is repatriated back to Japan.  Seasonally speaking, however, the yen tends to do much better in April than either of those two months.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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