Since the middle of June, the Dollar and Japanese Yen have outperformed other currencies because of their safe-haven status. We think this will continue over the near-term but believe both currencies can move substantially lower in the long run.
Stock markets drifted lower again this week on continued concerns about the strength of the global economic recovery. The Dow Jones Industrial Average finished the week at 8,146.52, down 134 points (1.6 percent), while the S&P 500 Index closed Friday at 879.13, off 17 points (1.9 percent). Meanwhile, the US Dollar and Japanese Yen gained against other major currencies. The Dollar gained 0.4 percent vs. the Euro and 1.1 percent against the British Pound. But the Yen outperformed all currencies, finishing the week with gains of 3.6 and 4.1 percent against the Dollar and Euro, respectively.
For the first six months of the year, the dominant forces driving currency trading have been the desire to acquire risky assets during periods when the economic outlook was improving vs. the need to find safe-haven assets in times of economic uncertainty. From March until the middle of June, traders were encouraged by reports that the end of the recession was in sight and bought the Euro, Swiss Franc and British Pound accordingly. These currencies were considered to be riskier assets.
Since mid-June, however, the economic news has generally been disappointing and traders turned to the Dollar and, especially, the Yen as safe-haven currencies. The Dollar has traditionally been considered a safe-haven currency but putting the Yen in this category seems counterintuitive. The US economy, until late-2008, has been the strongest economy, among developed nations, and would appear to warrant the Dollar's safe-haven status. The Yen, on the other hand, represents an economy that only recently emerged from its so-called "lost decade," during which it struggled with slow economic growth and near-deflation. Even now its economic prospects appear bleaker than those of any other developed nation.
In this article, we will examine the prospects for, first, the continuation of the risk vs. safe-haven scenario and, second, look at the prospects for both the Dollar and the Yen in coming months.
Analysis
In addition to its role as the currency of the largest and strongest economy in the world, there have been two other reasons for the Dollar's status as a safe-haven currency: its continued strong performance from roughly 1981 through 2002; and its role as the reserve currency of the world. There are signs that all three of these reasons are becoming less important to investors.
In most other global recessions, it has been the US that has led the world to recovery. Because of the demand by US consumers for world goods, many countries have come to depend on the US to support their own export-dependent economies. This has been especially evident in the emerging economies, but developed nations like Japan and Germany.
This time the situation could be significantly different. US consumers, who in the past, took on exceptional debt to fund their spending habits have become more concerned about reducing their debt-load, in effect, de-leveraging. As we pointed out last week, consumer spending which, in good times, constituted seventy percent of gross domestic product will not begin to approach that level for years to come. Consequently, US economic growth, as the country emerges from the recession, will be significantly slower than in past recoveries.
Before the US began to slip into recession, there was talk that the world economies were "de-coupling" - becoming less dependent on the US. But when the US economy started to slide, it quickly drove the rest of the world down with it. Now, however, there are signs that some economies, especially among the emerging markets, may be starting to recover without help from the US. China, India and Brazil all seem to be doing well without US help (although there is some question as to how effective, long-term, China's stimulus package will be, and to how quickly Brazil recovers should commodity prices began to decline again). Consequently, we are once again hearing the "de-coupling" talk.
Should the dominant economic role of the US continue to decline, and, as international investors begin to realize this, they could begin to look for alternatives to the Dollar.
In 1981, after Ronald Reagan was elected President, the Dollar became the favored currency among international investors. Part of it had to do with Reaganomics but much also resulted from the global perception of Reagan as a strong leader, particularly after the fall of The Berlin wall and the demise of Communism. It also came from the respect accorded the US in the world.. Most traders that I talked with in those days had one strategy: buy the Dollar on any weakness.
The perception of the Dollar changed with the election of George W. Bush. The US lost respect throughout the world and the Dollar declined with that loss of respect. Perhaps Obama can regain some of that lost respect. Most analysts today, however, appear to believe a further decline in the Dollar is inevitable.
Lately, there has been much talk about the need for a new global reserve currency. In March one of China's top central bankers called for increased use of the IMF's special drawing rights as a partial replacement for the Dollar. More recently, the Russians have joined the chorus calling for a new reserve currency. In the past two weeks, the Chinese have made two more moves toward moving away from the Dollar. One week ago, the Chinese passed several rules authorizing specially-approved companies to begin pricing goods in renminbi. And Thursday, at the G-8 meeting in L'Aquila, Italy, a Chinese official again called for development of a new reserve currency.
Much of the talk about the need for a new reserve currency is politically-motivated. There is widespread resentment of the United States and its apparent attempt to exercise global hegemony. Talking down the Dollar is one way to bring the US down to size.
A short-term move out of the Dollar is not realistic. China, Japan and Russia have substantial amounts of Dollar reserves invested in US treasuries and other securities. Any immediate whole-sale move out of the Dollar would drive the Dollar down and cause massive losses in these countries' portfolios. So any large-scale selling will not happen. But look for these countries to do what they can to ensure future diversification. The US cannot become complacent about its current status.
The strength of the Japanese Yen is harder to fathom. Until a year ago, the Yen was the weakest of all the major currencies. Interest rate differentials had been the most important factor affecting currency values, with traders buying those currencies whose countries had higher interest rates. The Yen had also been a key part of the so-called Yen-carry trade: Traders and investors would borrow Yen at Japan's near-zero interest rates, sell the Yen, and buy higher-yielding securities in other currencies. Ultimately, when the trader unwound the trade he would be able to buy back Yen that had depreciated since the original sale. These trades had been consistent winners.
In 2008, with asset values generally plummeting, traders were forced to liquidate various positions to cover losses on these assets and the Yen-carry trades were some of the first to be liquidated. The massive liquidation of these trades drove the Yen higher. As the Yen began to appreciate, it gained momentum. It soon developed a life of its own and became another safe-haven currency.
There is very little fundamental reason to buy Yen. Japanese interest rates are virtually zero and have been near zero for a long time. As mentioned above, Japanese economic prospects are not good.
There has been some good news out of Japan in the past week. Growth in Japanese industrial output matched a 50-year record in May (albeit from a very low level), exports appear to have stabilized, and Japan's Tankan index showed improvement in the April-June quarter (although still extremely negative). However, Japan's GDP contracted by 3.6 percent and 3.8 percent in the last two quarters and is expected to decline by 6 percent for the entire fiscal year.
Japan faces an output gap (the difference between actual growth and potential growth) of 8.5 percent. One private forecaster has predicted that the Japanese economy will grow at a 2-percent pace in the fiscal year beginning next April. But the government's own Advisory Council on Economic and fiscal policy forecasts only 0.6 percent growth for next year. Economists project that it could take Japan 3 to 5 years to reach the growth rate it achieved in the first quarter of 2008.
Japan's main problem is that its economy remains heavily dependent on exports. Japan thus is reliant on growth in both the US and Europe. Slow recovery in those areas means an even slower recovery in Japan.
One potential negative factor traders should consider when buying Yen is the possibility of currency intervention by the Bank of Japan. Japanese officials are well aware that the strong Yen is making it even harder for Japan's export-dependent economy to recover.
Forecast
We expect the economic recovery in the developed nations to be slow and to proceed in fits and starts. The uncertainty associated with this type of recovery should mean that investors will continue to seek out safe havens, specifically the Dollar and Yen, at least for the short-term. As the year progresses and signs of economic recovery become more evident we would be a seller of both currencies.
Indian Markets
Indian stocks suffered their biggest weekly decline in eight months. The BSE Sensex Index finished the week at 13,504.22, a decline of 9.4 percent. Selling began in earnest on Monday with the announcement of the budget. The budget emphasized support for the poor and for the economic recovery instead of stressing the economic reforms investors had been hoping for. The Sensex fell 5.8 percent on Monday alone.
The Indian Rupee closed the week at 48.91 Rs. per Dollar, down 2.6 percent for the week. The Rupee suffered the same fate as other risk-oriented currencies, with traders moving into the Dollar and Yen, the safe-haven currencies.
We look for both stocks and the Rupee to continue their trend lower next week.
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