A Crowded Currency Market Radar Screen

February 14, 2013

The foreign exchange game is not just about currency war, both real and imagined.  Those with exposures also need to keep an eye on economic growth after awfully weak fourth-quarter figures and trends in long-term sovereign debt yields and equities.  Important events are fast approaching like the Italian election on February 24, U.S. federal government sequestration on March 1, and Bank of Japan leadership change after March 19.  China’s at a critical cross-roads for both domestic policy and politics and foreign relationships. 

Currency wars are uppermost in investor minds, as a G20 statement on the matter and other issues is awaited this weekend.  G7 finance ministers and central bank chiefs made a hash of their effort to get out front with a statement on currency policy do’s and don’ts, and that experience illustrates a fundamental aspect of currency warfare, namely its guerrilla style.  Before the ink dries on joint statements of shared goals, individual governments interpret the meaning and are countermanded by representatives of other governments, who as often as not keep their true identity a secret.  Nobody’s going to intervene, that is conduct actual market operations that sell own currency against somebody else’s money.  The battle is done with words, backed up by fiscal and monetary initiatives that may or may not be effective.  It’s hard to imagine the G20 going beyond in writing the paragraph below from the G7 on Tuesday with any explicit sanction of the Japanese government headed by Shinzo Abe.  The real battles of currency warfare are waged with a myriad of impromptu remarks made from the sidelines.

We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate.

Euroland, Britain, Japan, and the United States reported annualized sequential GDP contractions last quarter of 2.4%, 1.2%, 0.4% and 0.1%.  Between the final quarter of 2011 and 4Q12, real GDP rose only 1.5% in the U.S. and 0.3% in Japan.  British GDP was unchanged on year, while Ezone GDP fell 0.9.  Exports, which governments hope to stimulate by encouraging more competitive currencies, performed poorly last autumn, plunging 14% in Japan from 3Q and by 5.7% from 4Q11. U.S. exports sank 5.7% on quarter and firmed just 1.4% on year.  In a trade war with retaliatory competitive devaluations, two-way commerce has historically spiraled downward, making everyone a loser.  That’s why governments try to show solidarity on currency management.  It’s a good strategy in normal times, which these are not.  Many central banks have near-zero interest rates.  Fiscal austerity isn’t succeeding anywhere.  It’s very hard for democratic forms of government to enact structural reforms, and such can take considerable time afterward to reap desired improvements.  The temptation to manipulate currencies stems from the tiny set of viable alternative ways to boost growth satisfactorily.

Several developed economies have experienced a significant rise of bond yields from an ultra-low base during the past three month.  This has happened in spite of tame inflation.  Ten-year Treasury and British gilt yields have risen about a half percentage point, and German bunds are up almost 40 basis points.  Investors need to ascertain if the move reflects a correction from an excessive bull market or a trend reversal that is likely to continue or intensify.  And if there has indeed been an enduring reversal that is to be extended, share prices could become ripe for a sell-off.  Meanwhile the tiny 3-bp increase of the 10-year Japanese JGB yield is consistent with the deteriorating value of the yen, and according to the Economist’s Big Mac index, Japan’s currency has swung from a state of near equilibrium six months ago to being now about 20% undervalued.

The outcomes and ramifications are uncertain of the U.S. sequester, Italian election, Spanish corruption scandal, and Bank of Japan leadership turnover.  They are very difficult to price into financial markets.  Unexpected results can become game-changing events.  Later in the year, Japan will be holding upper house parliamentary elections on July 11, and Germans elect a new lower legislative house on September 22.  These will be crucial to the future policies in those nations.  China, a country with enormous offshore financial holdings, has another fluid political scene, both domestically and from the standpoint of relations with its allies and potential foes.  Oil prices are frothy in spite of the disappointing state of real economic activity in developed countries, which are the ones with the monies whose future likely trend currency market players are anxious to know.  Time is getting preciously short to address global warming before the consequences become apocalyptical, and an irony of this age of electronic social networking  is that social fabric is becoming more, not less, frayed by technology and the unchecked inequality of incomes and education opportunities that such is abetting.

It’s been said of 2013 that while growth prospects in the developed world remain sub-par on balance that for the first time in many years, risk seems skewed to the upside.  If true, this would suggest a ripe environment for a number of currency reversals, with the yen starring in the opening act.  But from where I sit, a whole lot of stuff can still go badly wrong.  Financial market trends know no time limit.  In Japan, for example, overnight money rates have been 0.5% or lower since September 1995, and the Nikkei composite index of equities is still 71% below its 1989 peak.  Being in the sixth year since the U.S. subprime debt crisis ignited a global meltdown or in the fourth year since the onset of a sovereign debt crisis in Europe is no guarantee that more normal times lie just ahead.

Parity represents the epitome of a currency relationship that is sitting on the fence, waiting for uncertainty to diminish.  Two of the U.S. currency’s relationships are doing just that — the loonie and the Aussie dollar.  In both instances, economic fundamentals seems to be gravitating toward greater support for the U.S. dollar.  While this has been happening for the past few months, the gravitational pull of unity remains enormous, and one can infer that inertia to be a sign that investors aren’t yet prepared to see 2013 as the start of a more hopeful chapter for developed economies.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.


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