A Four-Ring Circus

March 6, 2014

Global investors and currency market watchers have lately been watching four acts.  In ring number one is the standoff between Ukraine and Russia.  Geopolitical events are generally shooting stars, exerting considerable market pressure at first but without the sustainability to dominate for long.  The Putin gambit backfired when the ruble and Russian security prices were among the hardest hit by risk aversion.  If Crimea erupts into fresh conflict, the most exposed economies will be Russia’s and those in Europe dependent on imported natural gas produced in Russia.  Markets are betting on a soft landing to the dispute because potential benefits far exceed the potential costs.  If The conflict escalates, that will reflect an irrational misjudgment in the diplomacy.  Markets are betting that doesn’t happen.

In ring number two, Chinese officials are attempting to rebalance their economy to a more balanced composition of growth with greater consumption but less investment and fewer imports.  In an economy of China’s size and population, that’s a terribly difficult undertaking and one that easily could cause growth to undershoot the desired target of 7.5%.  The target represents only a marginal dip from 7.7% in 2013 and 7.8% in 2012 but a 3-percentage point decline from 10.4% as recently as 2010.  Last year’s pace of expansion was the weakest for China since 1999, and the rest of the world is only now coming to the realization that even if the Chinese leaders get what they want economically, a three-percentage point change in what had been a major driver of global growth constitutes a very meaningful adjustment.  Two very closely affected countries will be Japan and Australia.  Meanwhile, there is another theme to watch in the Sino ring, and that the more assertive Chinese foreign policy.  Plans for a double-digit boost in military spending this year have spooked other Asian countries, especially Japan and South Korea, and play into the hands of Japanese Prime Minister Abe’s predisposition to take Japan also in a more nationalistic, assertive direction.

Ring number three is the stage of central banking, which is no longer marching to the same beat.  An article screened on this site earlier this week presents evidence and argues that revealed ECB behavior indicates that Germany’s economic situation has and continues to exert disproportionate influence over ECB monetary policy.  That bias and the widening collective Ezone current account surplus have lifted the trade-weighted euro about 2.5% since the ECB’s easing in November, negating much of the intended easing of that earlier move.  Federal Reserve officials have made clear that only a drastic deviation of the U.S. economic outlook from their baseline expectation would interfere with the present pace at which U.S. quantitative easing is being shut down.  The pace is gradual, and it wasn’t introduced until the FOMC was correctly confident that financial markets would handle the shift without panic.  Fed policy is now better understood than ECB policy, and it includes a tolerance for higher inflation than the ECB will accept both now and in the medium term.  The trade-weighted dollar since early November has not changed in a meaningful way, and the euro is within challenging distance of acquiring a $1.40 handle for the first time since September 8, 2011. 

The Bank of Japan’s monetary policy is also on the hot seat.  Japan’s economy hasn’t accelerated as much as imagined ahead of the consumption tax hike at the end of this month and is looking vulnerable against that coming shock.  Abenomics is still failing is several respects such as the failure of exports to get a big boost from yen depreciation.  The expectation of belated easing by the Bank of Japan and worries about China have helped generate a roughly 4% trade-weighted yen slide since early November.

Bizarre weather has distorted interpretation of economic data in Britain, the United States, and Japan, but this fourth ring in the currency market circus continues to be treated like a transitory smoke screen whose effect will be reversed to a considerable extent later this year.  Weather extremes are a predictable outcome of global warming, and the evidence of man-made climate change is now considerable.  So what if there isn’t a lot of snow and bitter cold in the spring, summer and autumn quarters?  It won’t be really surprising if there is disruptive weather of a different sort — tornados, drought, excessive heat, hurricanes, whatever.  Weather that is now being treated in economic modeling as a random element may in fact have a large structural element.  It bring’s to mind the lyrics of Blowing in the Wind.  How many unexpected weather events will it take for the light bulbs to go on and people consider a more hostile environment as the norm rather than random changes in the weather?

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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