Currencies Remain Mostly Calm Ahead of the U.S. Fiscal Waterfall

November 30, 2012

Net movement in the currencies of major advanced economies have been comparatively small during the second half of 2012.  The yen has exhibited the greatest weakness, a slide of 3.2% against the dollar, but virtually all that loss occurred within the past month.  The U.S. currency otherwise has depreciated 2.5% or less against the euro, Swiss franc, sterling, Chinese yuan, and Australian, New Zealand and Canadian dollars.  Most of those bilateral relationships moved less than 0.5% this past week, and all except dollar/yen by less than 1.0% during November.  Suffice it to say, the arena of foreign exchange has not been a significant driver in the great deleveraging of global debt that is continuing.

These are interesting times in the world economy.  Growth has gone from sub-trend to slow, with a number of advanced economies either in or flirting with recession.  Current account imbalances have mostly narrowed, and inflation prospects are generally benign.  In most countries, a combination of quite accommodative monetary policy is counter-balanced by tighter fiscal stances.  Historically, such a policy mix when done unilaterally has tended to depress a currency, but present times are set apart from earlier times by how widespread the same macroeconomic medicine is being practiced. 

Democracies have been severely strained in the process of budget deficit reduction.  Voters are very polarized in Europe, America, and Japan.  Arguments exist over how best to rein in deficit spending and, more fundamentally, over the appropriateness of fiscal austerity imposed on a low growth/low inflation private sector landscape.  The give and take of fiscal negotiations, imbued with a lot of stalling tactics, has predictably generated enormous uncertainty and, to an extent, frozen currency markets from reacting.  Some developments in the process are rather counter-intuitive, To quote a recent U.S. Treasury Department report commenting on Euroland’s situation, the region is undergoing “the most aggressive fiscal consolidation of the advanced economies despite having the smallest cyclically-adjusted deficit and the lowest growth prospects.” 

The original sin of Europe’s quagmire is institutional, namely the creation of an irreversible single currency and a one-size-fits-all monetary policy imposed on a region with widely divergent tendencies.  Europe has been forced to make do with the truly ill-conceived monetary framework that it has.  The temptation when the European debt crisis hit the news three years ago was to assume that a big drop in the euro was a matter of when, not if.  However, the wait proved way longer than imagined, and the main lesson of the past three years has not been the impossibility of the task of forging a complete economic and monetary union but rather the lengths that officials are prepared to go in fabricating a series of short-term triages.  The narrowed bond yield spreads of Spain, Portugal, Greece, Italy, and Ireland suggest that risk surrounding the euro during coming months lies as much to the upside as downside.

In foreign exchange, crowds flock to the potentially largest train wreck, and Washington’s looming fiscal cliff has move Europe’s issues off to the side of the stage.  It would be incredibly awesome and equally remote if a major long-term fiscal deal gets done by December 31st.  The full fiscal cliff can’t be ruled out.  Stuff like the First World War occasionally happens despite dire known consequences.  A short-term accord halting many of the tax hikes is sufficiently plausible and captures, I believe, the current likeliest outcome that is being discounted in the marketplace.  Deadlines would be extended into the new year, and talks would continue after a new congress is seated.  Even that scenario would likely produce a magnified deterioration of confidence in the U.S. economy and political system.  U.S. growth would take a hit, but so would global growth.  It’s easier to infer ensuing trouble for equities than the reaction of the dollar.  I suspect key dollar pairs would not shift substantially, continuing the muted movement of 2012.

China just underwent a change of political leadership, and Japan seems likely to do so after the December 16 parliamentary election.  The aforementioned Treasury semi-annual FX market report speaks of some, albeit incomplete, progress in converting China to a more flexible, market-determined exchange rate system.  The yuan has risen, China’s current account surplus has fallen to a fourth of its peak relative size, and the country is accumulating foreign exchange reserves at a greatly diminished pace.  The bottom line looking ahead is that China will reform at its own chosen pace, and the yuan will not be allowed to appreciate so fast that Chinese growth is unduly compromised. 

The yen is widely considered to be overvalued.  A big and chronic current account surplus has evolved into a deficit.  Deflation persists, and so does a pattern of in-and-out recession with sub-1% long-term growth.  Japanese fiscal policy is seriously out of kilter, and monetary policy will become more growth-biased after the Bank of Japan gets new leadership in March.  The yen is currently about 38% and 27% stronger than its 25-year averages against the dollar and synthetic mark.  The next national government is likely to seek depreciation more as a direct objective than as a potential benefit of its monetary policy.

In the view of the Obama Administration, only Switzerland among the group of advanced economies has a “managed” exchange rate, and that exceptionality is not only acceptable but indeed appropriate.  The Swiss National Bank imposed a ceiling rate of 1.20 francs per euro that has been enforced since September 6, 2011.  A quarterly review of the policy will be done later this month.  The stance is needed to contain capital inflows amid continuing uncertainty about the euro, and a line in the sand will unquestionably be retained.  It’s even possible that the ceiling might be moved to 1.22 or more francs per euro.  The deflationary threat in Switzerland has not gone away.

British economic and price trends have been lately obscured by the disparity of reported data, with a mix of both upside and downside surprises.  The Bank of England prides itself on a decision-making process that emphasizes individuality over consensus building.  Even when the data are less conflicting, the BOE tends to produce more unexpected decisions than your average central bank.  That being said, officials seem a little less predisposed to extending asset buying soon.  The selection of Mark Carney to take of the reins as Bank governor in mid-2013 is believed likely to herald a somewhat more hawkish philosophy.

There was a flurry of speculation today that the Reserve Bank of Australia will cut its 3.25% Official Cash Rate at next week’s meeting for the first time in three months.  Five cuts totaling 150 basis point reductions have been implemented since November 2011, yet RBA officials still consider the Aussie dollar to be stronger than fundamentals warrant.

The Bank of Canada, which hasn’t changed its key interest rate since a 25-basis point increase in September 2010, also holds a policy meeting in the coming week.  An article in the Financial Times on November 29th defended the view that the C-dollar might be approaching a turning point for the worse.  It would be vulnerable to a deterioration of the U.S. economy.  The current account deficit equaled an unsightly 4.1% of GDP in both 2Q and 3Q.  Inflation is below target.  Canadian growth weakened to a mere 0.6% at an annualized rate in the third quarter, thanks to the first drop in business investment since 2Q09 and to an annualized drag of around 3 percentage points from net foreign demand.  The momentum of growth over the quarter actually tailed off in September.  The Bank of England’s acquisition of the hawkishly respected Mr. Carney is Britain’s gain but will be a loss to the Bank of Canada.  If global growth stumbles, so likely will commodity prices including oil, of which Canada is a large exporter.  Like their Australian counterparts, officials at the Bank of Canada have long noted that C-dollar appreciation exceeded what domestic fundamentals alone justify, the point being that monetary policymakers would welcome rather than protest a little depreciation.

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

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