The main feature of the foreign exchange markets over the past month has
been the further sharp fall in the euro. There has been no real change in
the background economic situation in the euro-zone; but there has been
a serious deterioration in the financial background as doubts have increased
about the ability of Greece and some other periphery countries to cope
with their massive fiscal deficits and service their sovereign debts.
This is clearly leading to a withdrawal of international funds from the
European capital markets, and is dramatically illustrated in the widening
of yield spreads in the bond markets of member countries.
There is still a general assumption that the stronger members will provide
support for the weaker members if this proves to be necessary to prevent
a default on sovereign debts.
But the uncertainties have been increased by conflicting statements from
the European Central Bank and some politicians about the willingness to
undertake such operations, and so investors and speculators have taken
evasive action, and the euro has fallen by around 10% from its peak in early-
December.
This fall has provided support for the other major world currencies, including
the dollar; but the background situations in Japan, and in the UK, also
provide reasons for concern, and so the currency markets remain in a very
uncertain state.
It is likely that the uncertainty will continue. The US economy is clearly
recovering from recession; economic conditions in Japan are very weak,
and Japan appears to face the possibility of a credit downgrade if it does
not take steps to reduce its massive fiscal deficit; and there have already
been warnings from Standard and Poor’s that the UK also faces the possibility
of a credit downgrade if there are no convincing measures to reduce its
huge fiscal deficit after the forthcoming general election.
Prospects are therefore very difficult to assess; but our tentative conclusion
is that the dollar will continue to “improve”, helped to a considerable extent
by weaknesses elsewhere; and that this will allow market pressures to
gradually subside as the global economic recovery continues through the
year.
But the possibility of a major currency crisis cannot
be ignored, especially if the debt problems in Greece
and other periphery countries threaten to lead to the
break-up of the single currency system in Europe.
It is fortunate therefore that the available evidence
on the performance of the US economy is more
encouraging. Non-farm payrolls fell again in December
by 85,000, but are expected to have increased in
January; retail sales held up well in the pre-Christmas
period; manufacturing output is improving, according
to the latest report from the Institute of Supply
Management; and even the housing market appears
to be recovering.
This general situation is reflected in the first
preliminary estimate from the Commerce Department
of growth at a seasonally adjusted annualised rate of
5.7% in the final quarter of last year, a higher figure
than the market had been expecting.
Most economists therefore appear to be forecasting
overall growth this year in the 2.5% to 3% range, after
the estimated fall of 2.4% last year.
The Fed is clearly in no hurry to tighten its present
monetary stance. The statement after the latest
meeting of its Open Market Committee was more
upbeat about the prospects for the economy; but shortterm
interest rates were left unchanged and close to
zero, and there was a clear indication that they would
remain at very low levels “for an extended period”.
The bank did state that it will discontinue most of its
emergency lending programmes, and that it would
end its purchases of mortgage securities in March; but
there was no indication that it would be prepared to
implement an “exit strategy” until there was
convincing evidence of a sustainable economic
recovery. It is also unlikely that there will be any early
changes in fiscal policy.
The recent State of the Union message to Congress by
President Obama included a request for the approval
of a further fiscal stimulus package this year amounting
to around $100 billion to help to tackle the
unemployment problem, and he has also presented a
$3.8 trillion budget for fiscal 2011 that is likely to
maintain the overall deficit around the $1.35 trillion
level expected this year.
Much will depend on the attitude of overseas holders,
and especially on the attitude of the Chinese and
Japanese authorities.
For the present they seem to be prepared to maintain
and even increase their dollar exposure; and if this
continues, and the problems of other major currencies
remain unresolved, it should be enough to allow the
dollar to “improve”.
The euro struggled to recover in the early part of
January from the big fall that occurred in December;
but the recovery did not last very long, and it has
subsequently fallen sharply again, to leave it value
against the dollar around 10% below the level in early-
December.
There has been no significant change in the underlying
economic background, although there is some evidence
that the fragile recovery that was developing is losing
some momentum.
But there has been a serious deterioration in the
financial background as the fears have increased that
Greece and some other periphery countries in the
euro-zone may be unable to fund their massive fiscal
deficits, and service their sovereign debts.
There is also considerable uncertainty about the
intentions of the European Central Bank and the
stronger countries if conditions continue to worsen,
and so overseas holders have started to withdraw
funds from the European capital markets to await
developments.
The present lack of urgency at the central bank and
amongst the key politicians suggests that this trend
will continue, and that the euro will fall still further;
but there is still some hope that the seriousness of the
situation will finally produce a support operation that
will ease the situation.
All the available evidence continues to point to a slow,
two-speed recovery in the euro-zone economy.
Germany and France appear to be performing
reasonably well, although there are some signs of
slowdown in Germany; but Greece, Portugal, Spain,
Ireland, and even Italy are struggling to escape from
recession, and are expected to keep overall output in
the euro-zone this year around the 1% level.
There is also considerable uncertainty about the intentions
of the European Central Bank and the stronger countries
if conditions continue to worsen, and so overseas holders
have started to withdraw funds from the European capital
markets to await developments.
Retail sales remain depressed, and fell by 1.2% between October and
November to reflect the continuing caution of consumers; and industrial
orders in Germany rose by much less than expected in November, after a
very disappointing result in October, to indicate some weakness in export
prospects that had been expected to provide significant momentum to the
economy.
Prospects therefore remain disappointing, and are being made worse by
the differences that exist between member countries.
The European Central Bank therefore faces a difficult situation. It continues
to forecast “moderate” growth and “moderate” inflation; but it is being
severely criticised for failing to address the problems of a two-speed
economy, and for its unwillingness so far to face the threat that the
deteriorating situation in Greece could quickly begin to destabilise other
member countries and have serious consequences for the financial stability
and growth prospects of the entire area.
It is not surprising therefore that investors and speculators have started
to reduce their exposure to the euro.
The critical question therefore is whether the fall of the euro is now over.
Since the currency is unlikely to receive any real support from the general
background situation in the euro-zone, everything depends on the
developing debt situation, and particularly on the situation in Greece; and
also on the possibility of support operations from stronger member countries
and from the European Central Bank, and the European Commission.
The situation remains uncertain. The central bank appears to be reluctant
to offer help, and the German government, which might have been expected
to become involved, has also made no response so far.
But the European Commission has endorsed the latest plans by the Greek
government to introduce an across-the-board freeze on public sector wages
and cuts in allowances that are expected to reduce the overall public sector
wage bill by around 4%.
This may encourage support from elsewhere; however the Commission has
warned that it will not tolerate any slippage from the target and will if
necessary demand tougher action from the government to ensure that it
stays on course.
But it is far from clear that the Greek government can obtain the necessary
support in parliament even for the present proposed measures, and so the
uncertainty will continue.
It is therefore likely that there will be further falls in the euro over the
coming weeks.
Sterling has improved slightly over the past month, helped by the weakness
of the euro.
The background situation in the UK remains unattractive, and there have
already been threats that its AAA credit rating is at risk unless there are
credible measures to reduce the massive fiscal deficit after the forthcoming
general election is over.
The European Central Bank therefore faces a
difficult situation. It continues to forecast
“moderate” growth and “moderate” inflation;
but it is being severely criticised for failing
to address the problems of a two-speed
economy, and for its unwillingness so far to
face the threat that the deteriorating situation
in Greece could quickly begin to destabilise
other member countries and have serious
consequences for the financial stability and
growth prospects of the entire area.
But the UK is not constrained by membership of the European single
currency system, and so there is no immediate risk of a default on its
sovereign debts.
It has therefore been able to benefit from the problems affecting some
other European countries.
The latest figures from the Office of National Statistics indicate that the UK
just managed to move out of recession in the final quarter of last year. The
estimate of growth of only 0.1% in the quarter was a considerable
disappointment, and it is expected that it will be revised higher; but clearly
the economy is not performing very well.
Government spending remains strong, and there was a surge in retail sales
in the run-up to Christmas; but the anecdotal evidence suggests that
consumers became much more cautious again in January.
The latest meeting of the Monetary Policy Committee of the Bank of England
was concerned by the poor reaction so far to the dramatic measures that
have been introduced to counter the recession, and reacted to this situation
by leaving UK base rates unchanged once again at 0.5%.
It clearly has no intention of moving to an “exit strategy” until there is
convincing evidence that a sustainable recovery in the economy is underway.
It did announce that purchases of market securities under the quantitative
easing programme would now be discontinued after the £200 billion target
has been reached; but its main priority is to continue to provide support
for the fragile economic recovery.
Fiscal policy is also likely to remain unchanged until after the election,
because the necessary measures to reduce the huge deficit will be unpopular,
and might influence the outcome of that election.
Sterling is therefore receiving no real support from the domestic background
situation, and in other circumstances might have been expected to move
lower.
But the problems affecting the other major global currencies, and particularly
the problems affecting the euro, have at least delayed any further falls.
The yen has improved over the past month, despite a generally unfavourable
domestic background situation, and some attempts by the Japanese
authorities to prevent its appreciation against other currencies.
It has achieved an enhanced “safe haven” status in the current storm in
the currency markets, and on the back of the relative success of its exports.
But conditions in the Japanese economy remain very weak, and there has
even been the threat of a downgrade of its credit rating unless measures
are introduced to reduce its massive fiscal deficit.
However it does not appear that this threat will prevent the new Japanese
government from introducing further measures to stimulate the economy,
and urging the Bank of Japan to intervene in the markets to weaken the
yen, and so its prospects remain very uncertain.
