Can’t Get There from Here

February 21, 2013

A state of considerable uncertainty always surrounds financial decisions that need to be made.  In the past, there tended to be more type A uncertainty among currency market participants than now, which results when people believe they understand cause-and-effect relationships better than they in fact do and as a result under-appreciate the complexity of predicting the future.  Let me illustrate.  As an economist with Chemical Bank’s Foreign Exchange Advisory Service in the early 1980s, I routinely participated in a group exercise every five weeks of forecasting dollar values against a number of other flexible currencies for the end of each quarter going out a year.  Opinions were based on a grasp of influential currency market determinants and our outlook for key economic trends in the G7 economies.  Conclusions were often held strongly, and a wide consensus was shared that dollar strength would prove transitory.  In one stretch, nonetheless, 31 of 36 projected dollar values proved to be on the wrong side of market forward rates at the time when projections were made.  In hindsight, market behavior proved more uncertain than we had realized.

The quality that distinguishes uncertainty faced in the post-2006 era from before is a greater recognition that one simply doesn’t know how developed economies are going to resolve the problems of unsustainable imbalances and trends or, more importantly for that matter, if any feasible means exists for doing so.  Japan has been trying for two decades without success.  The malaise for other advanced formerly industrialized economies has been shorter only by comparison but now also exceeds a half-decade.  Basic fault lines seem formidable.  Developed countries were unprepared to handle changes forced by the technology revolution, such as the disconnection of productivity growth and workman’s wages, or for another example, increasingly scarce available jobs that require labor endowed with only average or below-average intelligence and academic achievement and knowhow. 

Central banks have had to play too large a role in staving off short-term economic disaster.  Successive rounds of quantitative easing by the Fed has avoided a double-dip recession in the U.S. and helped shepherd the jobless rate back from 10.0% to 7.9%, but economic growth remains a shadow of its previous self.  The European Central Bank’s OMT scheme, which has still not been utilized, dissipated widely held convictions of an imminent break-up of the common currency, but improved investor sentiment hasn’t stopped regional recession, and a socially feasible formula continues to be absent that will restore the competitiveness of the group’s weak economies.  Japan’s Nikkei is 32.5% higher than in mid-October on the promise of new policy priorities, which on close look aren’t very different from things that were tried and ultimately failed before.  Japan will engage in heavier use of quantitative monetary easing (QE), even as central bankers elsewhere are expressing misgivings about diminishing benefits and mounting possible costs from maintaining QE programs. 

It’s hard to escape the conclusion that economies may never dig out from their present hole — that no set of policies or deregulatory laissez faire exists to fix what’s presently wrong, whether that be elevated long-term unemployment, unaffordable health care systems, or apocalyptical climate change.  The one predicted risk that hasn’t occurred has been accelerating inflation.  U.S. consumer prices rose 1.6% over the twelve months through January, less than their four-year pace of 2.2%.  German inflation has declined to 1.7%, and Japan’s deflationary beat just goes on and on and on.  Inflation differentials are too small to give currency markets direction. 

Yes-we-can hopefulness in the U.S. and other developed countries has been replaced by a resignation that things are what they are and will stay as such.  Politicians have been the object of frustrated venting for being a messenger of broken promises, but the inventive nerds of technology were the real game-changers that got nations into their present fix.

With market sentiment buried under oppressive uncertainty and gloom that most initiatives will repair damage only for the short term, most currencies have simply hunkered down in comparatively tight ranges.  The dollar is less than 2% from its post mid-2012 averages against the Aussie and New Zealand monies and just 2.5% from the equivalent C-dollar and euro means. 

The main exceptions involve the yen and pound.  Prodded by verbal intervention, the trade-weighted yen has depreciated 13% over the past three months and by 17% over the past half-year.  That contrasts with less than a 1% move in the trade-weighted dollar over both those periods.  The trade-weighted euro climbed by about 4% since November 21 and by around 6% since August 21, but no part of those net gains were made over the last month.  Sterling has dropped 3.4% in trade-weighted terms in the past month, almost as much as the yen, and is down 6% since August 21.  Prior to its latest stumble, the euro soared 35.7% against the yen between July 24 and February 6 including 26.6% subsequent to November 14.

Being otherwise baffled, currency markets are getting the bulk of their directional energy from outright verbal intervention and subtle innuendos that are inferred as such. The latest minutes of central bank policy meetings, whether from the Fed, Bank of England, Reserve Bank of Australia, Reserve Bank of New Zealand, or BOJ — and the ECB’s press conference — have each elicited meaningful currency market reactions.  At the moment nobody wants their currency to strengthen, and several are striking back at the Japanese Blitzkrieg. 

It is much easier to debase one’s money than to strengthen it.  If authorities are willing to subordinate all other priorities to a weakening currency, it should succeed if acting unilaterally.  If many countries follow this strategy, the one whose currency goes down is the government that doesn’t flinch in a game of chicken or at least communicates its intention most brazenly.  But in general, as the exercise is more widely practiced, the ramifications become more uncertain and will bestow less market guidance.  The 100 yen per dollar level could prove elusive, and it may be that the yen needs to strengthen to or through the 90 level, regroup, and make another downward run before breaking on through to the other side of 100.

As for sterling, it is extraordinary when a central bank’s top official sides with the minority on a monetary policy proposal as Mervyn King did in January by voting for an expansion of quantitative easing.  The Bank of England targets inflation, which has stayed above the objective for years, but even the majority appears to have a directional bias toward easing at its next move.  In the game of chicken, some central bank officials around the world are getting cold feet about unlimited quantitative easing, and where that view becomes reflected in actual policy actions or gets constant vocal expression, currencies are likely to be better bid.  That will be a pity.  There’s little glory in promoting currency strength in a world with few other options for enlivening economic and employment growth.

The week ahead begins with the results of Italy’s election.  If the result is inconclusive or worse than expected for the center-left, the euro could get hammered.  The week ends on March 1, the target date for the U.S. fiscal sequester.  That event looms as a crap shoot, both in terms of what politicians do and from the standpoint of how investors then react.

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

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