Exchange Rate Adjustments
January 26th, 2009 - Increasingly, currency markets have to deal not just with the usual fundamentals but also with government policies and their potential impact. Of course, government talk and action have always been important factors that traders normally take into account. But in current circumstance, they loom even larger than before.
The pound’s decline has caught everybody’s attention, as they have observed its vertiginous drop against the euro and the dollar. The punishment wrought on the hapless currency is not unrelated to the state of the UK economy, which is simply awful. It has many of the problems of the larger economy across the Atlantic: a housing crash, a banking bust and overstretched consumers. Unfortunately, it does not have a currency with reserve status.
By some estimates, the housing market is in an even worse shape than in the United States. And the banking system has loads of toxic waste, as well as exposure to dodgy assets in emerging countries. Major banks have already been partially nationalised and may still need further propping up. Private risk has been transferred to the public sector, with the result that credit default swap rates for government debt have spiked higher.
The Bank of England, having cut interest rates to historically low levels, is almost certain to reduce them further. It is also actively looking towards engaging in quantitative easing to relieve problems in the financial system and get credit flowing again. If the government ends up nationalising the banks entirely, the task may become even easier. Profit motives would go right out of the window. Lending to dodgy borrowers would increase, and banks would be instructed to buy tons of debt that the government is going to issue in massive quantities. The huge issuance of gilts is of course the result of the stimulus package brought in by the authorities.
Comments in the media by Jim Rogers, the successful hedge fund manager (there are a whole lot of unsuccessful ones out there), about the prospects of the UK economy were less than optimistic and rattled some nerves. He said that the country was essentially bust, with North Sea oil resources having already diminished, the financial sector in dire straits and not much else that was positive about the economy. His conclusion was to sell sterling, as well as any UK assets.
We have to admit that there is an element of truth in what Mr Rogers says, but it is also a bleaker assessment than is warranted. The financial sector has received a considerable blow but it is sufficiently resilient to regain some of the lost ground. In the longer run, though, there is likely to be a dispersion of financial activity towards Asian centres.
Meanwhile, the UK manufacturing sector is not dead and is actually a successful exporter. So the authorities aren’t averse to seeing a weaker currency at the present time. Not so happy about the matter, are the ever competitive French. Their finance minister has voiced her opinion about the issue of a depreciating currency recently.
But hers is not the sole voice on currency valuations. There has been a chorus of complaints and warnings in the past week alone. At the top of the list are the Japanese, who are very uneasy about the appreciation of the yen versus the euro and the greenback. But they can’t really put all the blame on foreigners. Japanese corporations have been quite busy repatriating funds from abroad and pushing up the value of the yen. For investors, a country with a current account surplus is an attractive refuge in a risk-averse world. It is notable that the yen’s exchange rate correlates with changes in risk appetite.
Another country with an even healthier current account surplus is Switzerland. Unfortunately, the strength of the franc versus the euro is a hindrance to a country so dependant on exports. With interest rates already cut virtually to zero by the Swiss National Bank, the utility of this policy instrument has been exhausted. But there are other measures that can be taken. So it is not surprising to hear a slew of officials warning that they are prepared to intervene to weaken the swissie, as well as engage in quantitative easing. The intervention threat is certainly credible because it is quite easy for a central bank to depreciate the value of its currency.
The US Treasury secretary wasted no time in reiterating the old mantra that the new administration is in favour of a strong dollar. This doesn’t mean a whole lot, and does not imply policy intervention to shore up the greenback. But it does signify that they would not be comfortable with the dollar sliding rapidly.
Well, for now, they don’t have to worry about that occurring, although the outlook remains cloudy. The dollar has recouped much of the ground it lost a few weeks ago. Interest rate cuts, quantitative easing and stimulus packages are rapidly being implemented almost everywhere. So the US may not look as unattractive as it did earlier because of its decision to implement aggressive policy measures first. Indeed, in the eyes of some investors, they may actually appear to be proactive and able to jumpstart their economy sooner.
Going forward, there is a good deal of uncertainty about a currency’s direction. First of all, given the weak global economy, governments are not interested in strong currencies and will act accordingly. Also, there will be different degrees of success in stimulating the various economies. Furthermore, the extent of policy errors will vary among countries. And all of this means that there will be lots of occasion for swings in exchange rates.