Weekly Foreign Exchange Insights
No end to extremely strained credit market conditions appears in sight. Officials are individually and collectively working feverishly to inspire confidence, but two litmus tests, credit market premiums and share prices, signal an escalating crisis. Risk aversion has buoyed the yen and dollar and depressed sterling and commodity-sensitive currencies. When G-7 finance ministers and central bank leaders met six months ago, they expressed great concern about a weak dollar and its “possible implications for economic and financial stability.” G7 officials have had their wish granted on the dollar but not for reasons they had hoped, and a firmer dollar did not promote financial stability or better economic prospects. On the contrary, just about every aspect of financial market life is worse, and the world now faces a recession, the likes of which may not have been seen in decades. Strengthened by forced asset liquidations and safety-seeking flight capital, the dollar has risen since the April G-7 meeting by 41% against the Australian dollar, 33% against the New Zealand dollar, 17% against the euro, 15% against sterling 12% against the Swiss franc and 14.5% against the Canadian dollar. The dollar climbed more than 20% against the Icelandic krona in the past month. In Asia, the dollar is 29% stronger than the Korean won compared to end-August, but it is 2% lower against the yen as six months ago. The yuan, which remains under the complete control of Beijing authorities, has not appreciated further for a couple of months.
Fear abounds from Wall Street to Main Street, but the prospect of a run on the dollar is not one of the concerns. For the patient investor, the dollar should keep working it's way higher. Except against the yen, significant advances were recorded in the last two weeks. When other assets perform poorly, the dollar improves. In common with other parts of the financial system, currencies are exhibiting abnormal volatility. The Australian dollar moved this past week in a high-low range with width of 20.0%, almost as great as the 22.4% band for all of 2007.
Concerted central bank intervention to curb the swings in currencies is unlikely. This week's coordinated interest rate change was the first such instance since the 9/11 attacks, and multi-nation participation in foreign exchange market intervention has experienced a longer lull, dating back to September 2000. The dollar is still about 15% weaker than its average euro value over the entire period since the common European currency was formed at end-1998. Moreover, officials have much bigger fish to fry than the dollar. Unilateral intervention by Japanese officials should not be ruled out, in contrast. In fact, such is likely if dollar/yen stays below 100 in an enduring way. Yen appreciation is a counter-intuitive development for an economy in recession. With foreign orders for Japanese machinery some 10.3% lower in July-August than in 2Q following a 4% drop in 2Q from 1Q, an appreciating yen is one of the the last things Japanese officials want to accept, and they have acted in the past to reverse yen advances beyond the 100 per dollar level. Against the euro, meanwhile, Japan's currency has become even less competitive, rising 12.5% since October 1st and 27% since July 23rd.
The dysfunctional nature of global financial markets has not festered this year due to a lack of policymaker attention or action. G7 officials understood the risks when they met in April, observing in their joint statement from then that
The turmoil in global financial markets remains challenging and more protracted than we had anticipated. In the context of a weaker economic outlook, financial markets confront the interrelated issues of: re-pricing of risk and significant de-leveraging; managing counter-party risks; accommodating balance sheet adjustments; raising capital; improving the liquidity and functioning of key markets.
The problems are much, much worse now and magnified by the sinking feeling among officials, workers, consumers, and investors everywhere that governments do not and, more importantly, lack the means to control events. In an environment fraught with uncertainty, a word sure to be included in today's statement, one can be fairly confident that sustained improvement in either financial markets or real economic trends is not yet close. With officials unmotivated to halt the dollar's rise and with currency movements detached from the toolbox of foreign exchange economic “fundamentals,” the dollar ought to end this month at firmer levels than now prevailing.
Among the reasonably-sized amount of data next week, little seems likely to move currency markets in a trend-changing way. Several countries release CPI, PPI, or wage data, but inflation is not a focus these days. Scheduled indicators for activity or demand are mostly of the second-tier variety. The big news-makers will involve what G-7 officials say and do and any distressful news involving specific financial institutions. Over-stressed markets are badly in need of a respite, and next week kicks off with Monday closures in the United States for Columbus Day, Japan for Sports Day, and Canada for Thanksgiving.
Sterling's singular weakness seems well-justified and likely to be extended. Financial services had comprised a relatively large share of British GDP and were disproportionately responsible for that economy's long previous period of expansion, which managed to avert contagion from the recession that the U.S. and much of continental Europe experienced early this decade. The pound had climbed higher and stayed elevated longer than analysts ever expected in that period. Britain was poorly placed to weather a breakdown of the global financial system, and officials cannot easily combat the effects of the crisis, because the budget and trade balance are each in bad shape. Inflation is comparatively high as well, constraining support from monetary policy support. Interest rates are at 4.5% and thus have more scope to drop than the rates in other G-7 economies. It is not inconceivable that sterling will drop eventually to its 1995 lows against other European currencies. The pound's mark cross dipped below 2.17 in November of that year compared to an implicit cross rate now of 2.47.
Larry Greenberg
CurrencyThoughts
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