Fear of 2008 rerun grips world markets, buoy dollar

Tom Tong08/Αυγ/2011Currency Updates

It was another dreadful week for financial markets worldwide, and the downward volatility in many markets brought back memories of the 2008-09 crisis to many investors. There has been a massive change in risk perception across the globe as growth estimates continue to be cut worldwide, the prospect of a new recession reappears, and, most critically, the political leadership of the biggest advanced economies appears to be unwilling and/or unable to respond vigorously to the growing challenges. The two main worries are still (1) tightening fiscal policy in the US and then UK on the face of weakening demand and 2)the continued worsening of the crisis in the European periphery, where Spain and Italy are teetering on the brink of sovereign debt unsustainability. As the news continued to worsen on both fronts, equities sold off worldwide, led to the downside by double digit percentage drops in European stocks. Commodities also fared badly. The dollar rallied strongly, up 1.3% in trade-weighted terms, though that’s less than we would have expected given the generalized flight-to-safety. The greenback was weighed down by rumours (confirmed on Friday after markets closed) that S&P would downgrade US treasuries for the first time in history.


The business sentiment surveys in the UK gave mixed signals last week. While these weeks numbers were not as bad as feared, the worsening global backdrop is forcing forecasters to downgrade their medium-term expectations of UK GDP growth and to delay their forecasts of MPC hikes further into 2012. The Bank of England met, and as expected left both the asset purchase target and the interest rate unchanged. The good news, such as it is, is that the global financial storm is focusing on weaker countries for now, and sterling held relatively well, nearly unchanged against the dollar and up almost 1% against the common currency.


Given the dire news coming out of the Eurozone, we continue to be surprised by the common currency’s resilience. Last week the peripheral crisis exploded as Spanish and Italian 10 year yields soared clear above the 6% mark. At the ECB’s monthly news conference, Trichet made a half-hearted effort to calm markets, sounding more dovish than expected and announcing further purchases of Portuguese and Irish bonds. However, its refusal to buy the debt of Spain and Italy further damaged sentiment, and spreads for these two countries soared again. It seems likely that the ECB will be forced by events to reverse itself yet again, and start purchasing Spanish and Italian debt as soon as Monday. However, it is becoming clear that the strategy of reacting only when catastrophe seems certain, and then only doing the absolute minimum to avert it, is seriously damaging business, investor and consumer confidence on the future of the Eurozone. This damage can already be seen in the weakening PMI numbers and particularly in the disappointing growth of consumer spending, as households increase their precautionary savings. To repeat, given this dismal backdrop, the fact that the common currency barely fell 1% against the dollar and that it continues to hold comfortably above the 1.40 mark is surprising to say the least.


It is a sign of how far expectations for US economic performance have come down that a mere 117,000 jobs created in July passes for good news. It is important to keep in mind that this is considerably below average, and insufficient to accommodate even the natural growth of the labour force, let alone start making a dent in the growing problem of structural, long-term unemployment. In spite of the grim economic news, the resolution of the debt impasse and the near-panic in markets brought the usual flight-to-safety bid to the US dollar, which rose 1.3% in trade-weighted terms. However, the news of the S&P downgrade of US Treasuries (released after market close on Friday), together with the increasing likelihood of ECB intervention in Spanish and Italian debt markets, may weight on the greenback in next week’s trading.

Other G10

As investors race to move money into the few remaining safe havens, the Swiss franc continued its relentless appreciation. This has actually opened up another source of global instability. Many of the mortgages and consumer loans in certain Eastern European countries (Hungary and Poland, primarily) were funded in CHF, in order to take advantage of the lower Swiss rates. As the Swiss franc appreciates, these debts become harder and harder to service, creating macroeconomic headwinds in those countries at the worst possible time. Since the SNB is reluctant to restart last year’s program of massive CHF sales, it is difficult to see what will slow this appreciation and bring some relief to both the Swiss and Eastern European economies.


Written by Tom Tong

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