Currency Market Volatility February 8, 2010, Bill Witherell, Chief Global Economist
Currency markets have become highly volatile, sparking a global retreat from risk and into the “safe haven” currencies, the US dollar and Japanese yen. It looks like this volatility will be with us for a while. In this note we will discuss some of the factors underlying the current market turbulence and suggest some implications for investors
This past week saw a sharp fall in one of the high-flying currencies of 2009, the Australian dollar. The Australian economy has been benefiting from the strong growth in its important export market China. The currency also benefited from Australia’s relatively high interest rates and a central bank, the Reserve Bank of Australia (RBA), which had begun a process of raising its policy rate in advance of most other central banks. Market participants were very surprised when the RBA announced on February 2 their decision to leave rates unchanged due to doubts about the strength of the recovery in the Australian economy. The announcement specifically cited the earlier than expected tightening of credit conditions in China and the effects this could have on Australia’s exports.
Any developments that raise questions about the continuing strength of the Chinese economy have global market implications. It is noteworthy that China has passed the US to become the most important market for the exports of other emerging-market economies. This is clearly the case for Brazil. Doubts about China’s future economic growth (which we do not share) contributed to the week’s declines in global equity and commodity markets. In the case of Australia, if we are right about China continuing to be the global growth leader in 2010, it seems likely that the RBA hold on further rate increases will be temporary and that the Australian dollar, supported by strong fundamental factors, will recover in the coming months.
The more worrisome development in recent days has been the global fallout from credit concerns in Europe that have spread from Greece to Portugal and Spain. It seems increasingly likely that Greece will be saved from the brink of default by the European Union (not by any individual member states or the European Central Bank as this is prohibited under the Maastricht Treaty). It is possible that the IMF will be called in; this is an alternative recommended this weekend by both the Financial Times and the Economist. The Fund would be in a better position to impose strict conditions and minimize moral hazard problems, which would be great with an EU bailout.
That risk was made clear last week as attention turned to other problematic states whose difficulties will need to be addressed, one way or the other: Portugal, Spain, Ireland, and Italy. There is more than a whiff of contagion in the air. Sovereign credit risk concerns have escalated and added to widespread doubt among investors that global policymakers, having succeeded in avoiding a deep global depression, can now engineer a sustainable recovery in the face of unsustainable fiscal positions.
It is not just the weaker Euro zone members that face serious fiscal difficulties. The long-term budget outlooks for the United States and Japan paint very depressing pictures. Globally a tremendous volume of sovereign bonds – in the trillions of dollars – will be coming to the markets this year, and investors will demand higher risk premiums. This will be particularly the case for weaker sovereign credits, as shown by the experience of Greece, Portugal, and Spain this past week. Eventually, it may well also prove to be the case even for the US.
The concerns about Europe and the global rush to “safe” US dollar assets resulted in the euro dropping to an eight-month low against the greenback by Friday’s close : 1.368 euros per US$. Additional declines in the euro in the coming weeks would not be surprising. One factor that would propel the dollar still higher is a further unwinding of the huge US dollar carry trade due to the apparent increased risk aversion in the currency markets. Any significant further adverse global development could lead to a rush to unwind these positions. The resulting disorderly surge in the US dollar would be very adverse for asset markets.
The need to avoid such a development was likely on the minds of the participants of the weekend meeting of G7 finance ministers and central bank governors in Iqaluit in Northern Canada. This being an “informal meeting,” there was no closing communiqué; but some of the participants spoke afterwards with the press. They indicated that much of the deliberations focused on financial sector regulatory reform and the need for coordinated action. All agreed to keep government stimulus programs going this year. Governor Trichet of the European Central Bank expressed confidence in the actions Greece is taking to address its problems.
The rise of sovereign credit risk concerns and of risk aversion in currency markets, together with doubts about the global recovery, have combined to cause equity markets to swoon in recent days, with the US market recovering most of the week’s losses on Friday, after European and Asia – Pacific markets had closed. The MSCI EAFE Index for advanced-economy markets outside of North America declined 3.9% for the week, with the biggest declines in Europe (Greece: -11.3%, Portugal: -8.5%, Spain: -9.7%, and for the total Euro zone: -6.3%), whereas small advances were registered in Japan, +0.3%, and Canada, +0.6%. The decline in emerging markets, -3.84% for the MSCI EM index, matched that for the advanced economies, with the largest declines, understandably, being in the eastern periphery of Europe (Poland: -10.9%, Hungary: -10.8, and Czech Republic: -8.1). It is interesting to note that the MSCI Index for China declined only 2.2%, despite the fact that concerns about China’s future growth appear to have been one of the reasons for the global sell-off.
We view last week’s equity market declines to be a correction in markets that appear to have gotten somewhat ahead of the recovery in the global economy. This correction may well have further to go. Certainly the level of uncertainty has risen, accompanied by increased risk aversion. But we have not changed our positive view for the global equity markets for the first half of 2010. The global boom in manufacturing continued in January. Services have not yet followed suit. Investment spending in the US is picking up and corporate profitability is strong. Even before the latest fiscal difficulties we saw Euro zone economic growth underperforming US growth in 2010. That underperformance may now continue well into 2011. The latest economic data for emerging markets have been strong, continuing to support this sector’s leading role in the global expansion.
A final word on Japan: The recent strengthening of the yen had little to do with the domestic economy and its moderate recovery to date. Rather it reflects the yen’s continued role as a safe-haven currency in times of heightened risk aversion, and a further unwinding of the yen carry trade, a process that began towards the end of last year. The end of Japan’s fiscal year in March will continue to underpin the yen in the coming weeks. Later, most likely after the July elections, we can expect the Japanese government to take further steps to stimulate the sluggish economy and (short of intervention) to encourage a reversal of the yen’s appreciation. As the actual and projected spread between US and Japanese short-term rates widens, we can expect the yen to again become the leading funding currency for the carry trade. A depreciating yen will be very helpful for Japan’s exports, which already have been rising for a year. The leading economic indicators for Japan have been improving for nine months.
Over the past three months Japan’s equity market, as measured by the MSCI Japan Index, has advanced by 2.93%, significantly outperforming the benchmark MSCI EAFE Index, which declined 6.93% over this period. At Cumberland we are beginning to believe that this outperformance will continue and have begun to add to the Japan positions in our International and Global Multi-Asset Class Portfolios. We are moving cautiously, being well aware of the many past reversals (“head fakes”) in this market. More generally, heightened caution on the part of investors appears to be called for until the global outlook becomes a little clearer.
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