The week past may have been the most wrenching in the history of US equities. From Monday to Friday the Dow lost 18.1%, the S&P 18.2% and the NASDAQ 15.3%. European and Asian bourses had their worst week on record and exchanges in Russia, Indonesia and the Ukraine halted trading. But once again, as stocks crashed and burned the dollar rode high. The US currency may have lost 3.8% against the Japanese Yen and traded even against the Swiss Franc but it gained against every other major currency: 2.0% against the Euro; 9.4% versus the New Zealand Dollar; 3.8% against the Pound Sterling; 16.2% against the Australian Dollar and 8.7% versus the Canadian Dollar.
The coordinated 50 basis point rate cuts by the central banks of the United States, the European Monetary Union, England, Canada and Sweden, combined with the earlier 100 point cut by the Reserve Bank of Australia and the smaller reduction by the People’s Bank of China killed any remaining rationale for the carry trade. Though the Bank of Japan did not reduce rates, its base stayed at 0.5%, the rate differential between high yielding currencies and the yen that had drawn so much risk capital to the yen crosses is headed into oblivion. The banks that cut will cut again and for traders these crosses are on a one way elevator down.
The degree to which the New Zealand and Australian Dollars and to a lesser extent the Canadian Dollar, the Euro and the Swiss Franc were fortified by their yen crosses is illustrated by the extraordinary capitulation we have seen. The nzd/yen and aud/yen have lost 38.5% and 39.6% since their respective peaks, the cad/yen 31.5%. The US Dollar has gained 27% against the kiwi, 33% versus the aussie and 28% against the loonie. The euro and its cross have seen similar movement with the euro/yen off 20% from its high and the euro down 16% against the dollar. Even the relatively low yielding Swiss Franc and its cross have declined with the swiss/yen off 15% and the franc down 18% against the US Dollar.
Since the beginning of the stock crushing phase of the credit crisis the currency markets have clearly viewed Wednesday’s rate cuts as a foregone conclusion. Why else sell the yen crosses so hard? Perhaps the equity markets, which had been clamoring for these cuts for several weeks, might have taken early comfort in currency traders’ opinion that rate cuts were a certainty.
It is true that some of the positive movement to the US Dollar is part of a mass flight from central bank rate inevitability in the yen crosses. But dollar strength is not just the byproduct of the collapse of the carry trade. It is also a vote for the supremacy of the greenback and the US economy. The currency markets are telling the economic and financial world where the recovery will take first and strongest root. This conclusion, perhaps unbelievable in the face of the current economic catastrophe, is supported by the current level of the US Dollar against its major competitors. The euro has returned to the level it held against the dollar before the eruption of the subprime problem last August. The Pound Sterling and all the yen crosses are far below the levels of last August, as are the Aussie, the Kiwi and the Canadian Dollar. Only the Japanese Yen and the Swiss Franc are stronger versus the US Dollar.
The clear preference for the US currency over that of every other country in times of crisis is historically understandable. The US has the largest unified economy in the world, the largest internal market, and the world’s reserve currency. No foreign economy or currency could well survive a US collapse.
Whatever measures are successful (or not) in stemming this economic crisis, currency markets are betting that the first beneficiary will be the US Dollar and its economy. Investors can rationally expect that the American government will not let its banking system dissolve and that it has the power to accomplish that task. The prime lesson Mr. Bernanke took from his study of the Depression, and the chief Fed policy error at that time was that it permitted and indeed encouraged a contraction of the money supply. At the risk of future inflation the Fed has poured money into the US financial system in unprecedented amounts.
Just as the currency market assumption that worldwide rates would have to come down surfaced when the financial crisis turned into a severe credit crunch and was illustrated by the huge selling of the high yielding yen crosses, so it appears that the ascent of the dollar is the currency market's judgment on the outcome of the economic crisis.
The original subprime and credit crises have far outstripped their source in the United States. As the US was the fount of the crisis so, at least in the opinion of dollar traders, will it be the source of the recovery.