The economic mood turned pretty morbid over the course of the past several days. Collectively investors continue to realize how little they knew six months ago let alone three months ago. Confirmation of recession in the United States along with some of the worst readings on record for manufacturing and now service sector data around the world have served to undermine investor appetite for anything other than dollars and yen. Investors are slowly stopping their search for a solution and instead realizing that the broad solution is government but that the devil is in the detail. In the meantime, the dollar and yen remain king and queen.
There are few crumbs of comfort to be had other than to note that change is ahead. What changes, apart from increased regulation, we don’t know. The one crumb of comfort we’d offer at a wake at this time is to note that time is indeed a great healer. From every other historic example of calamity there comes a silver lining. The Federal Reserve was born out of a crisis a century ago and the various codes and acts that followed the 1929 rout are still with us today. Crisis delivers change.
Given the freefall currently in evidence investors have to rethink the rule book and adapt positions accordingly. There is little sense in taking any risk right now regardless of the manicured trading parameters or how logical the risk reward looks on the surface. Asset classes are undergoing a healing process and while many remain liquid, violent movements are still very evident.
It’s still premature to conclude that a stimulus package of uncertain definition will set the locomotive back on its tracks. And in the meantime nations are taking small steps where they can to keep markets functioning. In most cases central banks continue to cut interest rates. The former carry-trade has been replaced with what one might call a ‘catch-up trade. Here as we have argued before central bankers are realizing that their domestic economy is likely to be strangled by high interest rates relative to the dollar and that those rates were only set in the first place to ward off inflationary pressures, which have long since been confined to the history books. The longer it takes to get to where the Fed is, the harder individual currencies get hit.
But over the course of the last seven days the dollar has risen 3 cents against the euro to $1.2625, more than four cents to $1.4750 against the pound, 1.5 cents against its northerly neighbor to $0.792 cents and 1.4 pennies against the Swiss franc to 82.29. While central bankers slash monetary policy and advise governments on fiscal stimulus we wonder whether allowing currencies to depreciate is so bad after all. In most cases these currencies are giving back plenty admittedly of multi-year gains against a weak dollar. But in some cases the pressure does create problems. Emerging markets are being crushed by rounds of currency weakness making it harder for economies to address the initial rounds of problems.
Enter the arena China, which this week seems to be basically abandoning its three-year old policy of peg abandonment and gradual tip-toeing into the waters of allowing the yuan to rise. If every other nation can allow their currency to weaken against the dollar it means that China is becoming less competitive if it does not. And with a rapidly deteriorating domestic economy that recently turned a net-exporter of crude oil, one senses that the Chinese government feels no shame in pursuing this policy of economic stimulus. Whether a trade war looms on the horizon is an entirely different question.
The watchword in the currency minefield still remains ‘volatility,’ which notched broadly higher over the week through Wednesday. The exception was in the Aussie dollar where the implied reading slumped to a much more acceptable 30% from 42% last week. The RBA obliged with a 1% rate reduction earlier in the week and following our ‘race-to-zero’ logic possibly helped alleviate some of the pressure on the currency.
One to watch will be the Canadian dollar, where political stability is fast slipping into an abyss of uncertainty matched only by that of the economy. Challenges to the ruling minority government by a broad coalition looking to usurp power in a huge tit-for-tat spending row are enough to set the wheels in motion for an immediate election. Investors don’t need this on top of weaker demand and revenues for crude oil and other resources, which have hitherto supported the growth of Canada. Implied volatility rose 4% to 25.95 in the face of a decline in the purchasing power of the loonie to 79.2 cents. Open interest on futures contracts at the CME rose 6% indicating a rise in bets that the currency is likely to test its recent lows.
The fortunes of the British pound crashed headlong into a very well built brick wall as retail spending and confidence measures careened southwards. The MPC will address interest rates again this week and a further 1% reduction seems to be on the cards. A near-5 cent loss in the value of the pound was accompanied by a creeping gain for volatility to 24.5% while futures traders were forced out of around 1,100 contracts as open interest dropped by 1%.
Whether or not the dogmatic ECB will keep pace in the race-to-zero is really up in the air as they decide on how hard to ease the repo rate from its current 3.25% this week. Convention and conservativeness dictates a steady-as-she-goes-over-the-cliff approach rather than a more pragmatic understanding of the paralysis that is evident around the eurozone. We still see little respite on the horizon for the euro currency relative to the dollar. In a sense one could accuse euro bullish investors of almost hiding behind the plight of the pound, which has been far more sensitive to weakening data. The euro is almost reacting as though it’s the antithesis of the dollar rather than a victim in its own right in the same way that the pound is.
Thus far, we can now see as far as the end of a rather ugly 2008. Some people are looking forward to what the 2009 prospects for the dollar might be. Sadly, we must revert to the two-handed economist for those predictions at this point. Right now there is no reason to abandon a long dollar, long yen approach simply because the news is worsening and the recession is lengthening in duration. The rationale that a recovery will increase risk appetite and so undermine the dollar is ultimately hard to substantiate since one must remember who will be at the vanguard of recovery when it comes. Leading the world out of recession – whenever that may be – will keep investors on their toes in search of yield and rising yield spreads. That’s not on the cards anytime soon given the current policy stance. However, time and change will deliver that.