After a weekend of semantic analysis the currency markets didn’t take long getting back to work – the euro was only a cent off its all time high by late morning. According to Dictionary.com the relevant meaning of volatility is: tending to vary often or widely, as in price – the ups and downs of volatile stocks. Not much danger of volatility here, not if the only way the dollar is going to go is down. Wouldn’t the more appropriate term have been secular decline? But maybe they aren’t against that, and the markets in turning the pressure back on the dollar, have read the signal exactly right.
In fact relative currency values are being driven principally at present by US economic data. As such I can’t see that changing. Employment, productivity, current account, federal deficit: all of these will, in the end, speak louder than any words. Since I am definitely bearish in my leanings as to how these will go, I have to imagine that the dollar will continue to fall, and the euro to rise.
However when it comes to the current European and Japanese ‘recoveries’ there is no getting away from the fact that part of the driving mechanism is currency movement. If the dollar is going down, then the euro and the yen are going up. This makes euroland and Japanese stocks attractive whatever the valuation put on the economic performance of the various regions. People anticipate that Japanese and European financial assets will continue to rise and that is why a lot of US money is going into the EU and Japan.
This is having a virtuous circle effect, and giving a fair bit of a push to recovery ‘especially in Japan’.
But here is where the economic theory inevitably kicks-in. There are two questions, the business cycle, and the financial architecture.
Firstly the markets are optimistic – I wouldn’t describe it as exactly a bull – since they apply standard business cycle theory, make a trend line, and imagine things must be on the up and up.
I don’t accept this reading, I think that too many historic linkages are ‘broken’ and we cannot be sure of very much. If I am right and the ‘recovery’ doesn’t come in the expected fashion in France and Germany, then there will be a correction.
Second issue: financial architecture. As I keep stressing we have a structural problem that was always there waiting to appear. Having one of the currencies as numeraire (the basis for valuation of all the rest, or put differently, the reserve currency) – in this case the dollar – was always going to present enormous difficulties if we had to do global rebalancing. Now, with the rise of the new economic powers in Asia there is no alternative but to accept the inevitability of the change. If it happens at a trickle rate, then just possibly there is no big deal. But if there is a rush for the door at some stage, then there is a big deal. That is what everyone is worrying about.
My feeling is that the euro cannot stand the high valuations which are going to be loaded on it, at least not without a large dose of internal deflation, and this would be very painful for other reasons.
So at some stage, the euro may drop significantly, or even worse crack at the seams, and at that moment the money will come out again, and maybe all of a sudden, as people again try to stay in the currency shift anticipation business. So let’s be clear: the risk here is not only of a sudden and destabilising fall in the value of the dollar, other currencies are at risk, and the possibility of this eventuality should give everyone plenty of cause for thought.
The Japanese government on Monday sought to portray the result of Group of Seven finance ministers meeting in Florida as a victory, while investors took a muted warning about “excess volatility” as an acceptance of a weaker dollar.
Yasuo Fukuda, Japan’s chief cabinet secretary, said: ?It was good in that it confirmed the shared view that exchange rate stability was important.?
Japan has spent unprecedented amounts on foreign currency intervention with the supposed intention of smoothing out sudden movements, rather than keeping the yen artificially low. Last year, it spent Y20,000bn and in January lavished a further Y7,155bn.
Jesper Koll, economist at Merrill Lynch in Tokyo, agreed with Mr Fukuda?s assessment of the Florida meeting, saying the G7 had ?turned Japanese?.
The dollar fell to fresh two-week lows against the euro and came under pressure against the yen on Monday as investors took the muted weekend warning from the G7 as a tacit acceptance of a weaker dollar.
Initially, the dollar rose sharply, and the euro slid to $1.2605 early in Asian trading from $1.268 late in New York on Friday. But by late morning in Europe, the single currency had climbed steadily to a peak of $1.2761, its highest in more than two weeks and little more than a cent off the $1.2898 lifetime high it reached in January.
Sterling reached a new 11-year high against the dollar on Monday at $1.8628.
The statement from the Group of Seven finance ministers and central bank governors said: “Excess volatility and disorderly movements in exchange rates are undesirable for economic growth.”