The buck’s back
No major financial market generates as much frustration and perplexity as the foreign exchange market – and it’s not hard to understand why. Take the last few days as a prime example:
A series of negative developments relating to the state of the US economy — which included a downbeat assessment from the Federal Reserve Board, as well as shockingly bad trade data for June – made it crystal clear that the economy is sliding downhill. The rate of GDP growth in the second quarter, the first estimate of which was a less-than-forecast 2.4%, will therefore be marked downwards in upcoming revisions, by between 1%-1.5%. The outlook for the second half of the year is accordingly bleaker. You would think that all this bad news would feed straight into weakness for the US dollar on global markets – in fact, continued weakness, because the dollar has been falling for some time. But you would be wrong: the dollar has been rising all week, and jumped especially sharply on Wednesday, after the trade date were published.
If the picture regarding growth in the American economy has been disappointing, then that of the Japanese economy has been even worse. Last week’s column noted some of the long-term factors at work in undermining the Japanese economy, while the short-term data show that the rebound from the recession of 2008-09 has run out of steam. Given this sorry state of affairs, compounded by the fact that the rate of interest in Japan is zero and even long-term government bonds give much lower returns than those of the US and large European economies, one would not expect the Japanese yen to hit a 15-year high against the US dollar this week – as well, of course, as continuing its relentless rise against European and other currencies. But that’s exactly what it did.
Further examples are available, but unnecessary. To compound the problem, there are also cases where a slew of negative economic news is followed by a decline in the country’s currency, in line with “economic logic” and “common sense”. The UK and the pound sterling provided a case in point of this nature, also this past week.
So what gives? One possible explanation, offered to me by a long-time banker who has seen the markets at work over several decades, is brutally simple and cynical. The markets — including even the biggest of them all, namely the global foreign exchange market — are systematically manipulated by a shadowy group of big players. These are banks and brokerages whose main interest is that there be movement and activity in the market, irrespective of which way prices actually go. Consequently, prices are pushed or channeled first in one direction and then in the other, unconnected to daily or short-term news and often seemingly unconnected even over long periods of time to “underlying economic fundamentals”.
This approach is the diametric opposite to the idea, beloved of academics and text-books, that markets in general and, perhaps especially, the largest, most liquid and most sophisticated market of all – the foreign exchange market – trade on the basis of available information and rational expectations arising from that information. Unfortunately, as noted above, it’s all too easy to show that short-term movements in this and other markets are often entirely unrelated to the flow of information reaching the market and to the expectations that might rationally be derived therefrom.
But it is also impossible to accept that the market moves are the result of random, almost arbitrary, manipulation. The sharp fall in the euro and other European currencies versus the dollar and other non-European currencies, that began last November and continued until early June this year, was driven not by anonymous-but-powerful speculators, but by the crisis in confidence about Europe, the European Union and several specific countries within it. This crisis began with the revelation that Greece was in dire straits and quickly morphed into a much wider panic.
But the massive support package, worth in excess of 1 trillion dollars, cobbled together by the EU and the IMF and awarded to the “PIGS” countries in May, eventually caused sentiment to change, at least temporarily. From a low of below $1.19 to the euro in early June, the euro recovered to $1.33/ euro a week ago. That recovery seems now to have ended and the primary trend, of dollar strength and euro weakness has reasserted itself.
Why that is happening when the US economy is getting weaker (and Germany looking good) seems very strange – but the parallel strength of the yen, which represents an even weaker economy, provides a clue as to an explanation. The latest data from the US and from China show that in both countries – the respective leaders of the developed and developing worlds – the pace of recovery is flagging and the economy is heading south. That is bad news for them, but even more so for a world which is increasingly dependent on these two now-sputtering engines.
The response of players in all the financial markets is to sell risky assets and move to assets viewed as not, or at least less, risky. These include the US dollar, US government bonds, the Japanese yen, the Swiss franc and Swiss government bonds – and that’s about the end of the list. Why these are considered safe, and whether and to what extent that perception is well-founded is another matter, but for the moment at least, that is how the markets view things. And that is why weakness in the American economy has generated the unlikely and counter-intuitive result of strength in the American dollar.