The shares of burger joint Shake Shack (SHAK) have undergone a steep pullback during the second half...
Biggest effect of a stronger euro and a weaker yen/dollar will be felt in emerging markets such as China and Brazil
12/18/2012 8:30 am EST
The tide has turned. The weather is changing. The momentum has shifted with the change in quarterbacks.
Anything works as long as it 1) describes the current reversal in strength by the euro against the yen and U.S. dollar and 2) reminds us that the reversal is itself easily reversed and that we don’t know much about the timing of that reversal.
I prefer “tide” myself because it suggests not just the turn in the currency markets but a change in the flows that all financial assets swim against or with. The reversal in the relative strengths of these big three currencies will, after all, have an effect on everything from earnings at big U.S. multinationals such as IBM (IBM) and PepsiCo (PEP) to the price of commodities and commodity stocks to the balance of imports and exports in China to the growth rate of the Brazilian economy.
The biggest effect, though, is likely to be on the prices of stocks in emerging markets such as China and Brazil.
The euro had been in decline against the dollar and the yen since the end of February through July 24. After a rally through October 17, it dropped again until November 13. During those specific declines and during that seven-month period in general, money flowed into dollars and yen and assets denominated in those currencies. A rising dollar weighed on the price of commodities such as gold and oil. Japanese exporters found themselves at a painful disadvantage in selling their goods—such as cars--to European customers who weren’t inclined to buy anyway as their economies slipped into recession. U.S. companies such as McDonald’s (MCD) reported disappointing earnings as cheaper euros from sales by European units had to be translated back into more expensive dollars.
For the week ended December 14 the euro finished at $1.3163 against the U.S. dollar and the yen closed at 83.52 to the U.S. dollar. The euro rose 1.8% this week to its highest level against the dollar since May 4. The yen dropped 1.3% against the dollar to hit its lowest level since March 21. The yen fell 3% against the euro to hit its lowest level since April.
How big a change is this? On November 9 the euro traded at $1.2694 to the U.S. dollar. The low came on July 24 at $1.2089.
Despite the recent recovery the euro is still down from its February 28 high for 2012 of $1.3454. Which does, of course, suggest that the euro could move higher in the coming weeks.
It’s not too hard to see why the euro has rallied against the yen and the U.S. dollar.
Partly it’s because of positive developments in Europe. In the past week EuroZone finance ministers approved both the next big rescue payout to Greece and the first (and easiest) stages of what would be a European banking union. The first took the possibility of a Greek default/economic shutdown off the table, for the moment. The second demonstrated, for the moment, that European leaders could make progress on their long-term agenda. Add in the lack of an interest rate cut from the European Central Bank on December 6—the bank kept its benchmark rate at a historic low of 0.75% for the fifth straight month—and you’ve got support for the euro coming pretty much from all sides. (The only negative news is that the EuroZone economy continues to contract and the recession is both widening and deepening.)
Contrast the non-action by the European Central Bank with the stimulus or stimulus to come from the U.F. Federal Reserve and (maybe the Bank of Japan.)
On Wednesday, December 12, the Fed announced that it would replace the $45 billion a month Operation Twist that expires at the end of December with $45 billion a month of outright buying of U.S. Treasuries. Add in the Fed’s continuing program of buying $40 billion in mortgage-backed securities a month, and the Fed is committed to pumping $85 billion a month into the U.S. financial system.
And for a long time. Before last week’s meeting the Fed had said that it would keep short-term interest rates at their current 0% to 0.25% level until the middle of 2015. On Wednesday, however, the Fed said it would keep interest rates at that level until unemployment dropped to 6.5%. On the current trend that could keep short-term rates at current levels until the end of 2015. And it’s only logical to think that the Fed won’t ease off on its current $85 billion a month in quantitative easing until it sees signs that the economic recovery is sustainable at the current growth rate or better. Quantitative easing could be with us for quite a while.
In Japan the opposition Liberal Democratic Party and its leader former Prime Minister Shinzo Abe scored a landslide victory in elections on Sunday, December 16, winning 294 seats (by a preliminary count) in the 460 seat lower house of Parliament. Abe had run on a platform that called for the Bank of Japan to begin “unlimited” buying of government bonds with a goal of adding stimulus to the economy until inflation reaches 2%. Japan’s economy shrank at a 3.5% annual rate in the third quarter and is expected to show a contraction again in the fourth quarter. The current inflation rate is near 0%. The Bank of Japan will either go with Abe’s program—and add massive stimulus to Japan’s economy—or it will resist the call from the political leader in order to preserve its independence, setting off a crisis. Either alternative will take the yen lower.
The Japanese election and the pressure it has put on the Bank of Japan could mean that country begins the New Year with a financial crisis. The United States is likely to begin the year in a analogous position with politicians still locked in disagreement about how to fix the fiscal cliff created by the expiration of tax cuts and the imposition of automatic spending reductions that take effect after the first of the year. And then, of course, there’s the fight over raising the debt ceiling. Nothing to roil the markets like a replay of the last debt ceiling battle that raised fears that the United States would default on its debt and that led Standard & Poor’s to cut the country’s credit rating to AA from AAA.
In contrast the horizon seems relatively clear in the Eurozone. Oh, none of the core problems in the EuroZone have gone away or have even really been addressed, but Europe’s political leaders have kicked some of the big worries a long way down the road. For example, the recent Greek rescue deal and payouts have, potentially, postponed the next round of the Greek crisis until 2014. The country looks likely to receive enough cash to meet its needs until then. (The likelihood is, however, that when we all get to 2014, the Greek debt load will still be unsustainable and the Greek economy will still be both in contraction and uncompetitive.)
It’s unlikely the EuroZone will do anything but hold the fort until after the German elections in the fall. Anything that smacks of putting German taxpayers on the hook for more funds to bailout Greece or Spain or Italy could cost German Chancellor Angela Merkel at the polls. Her preference is for more talk from Mario Draghi and the European Central Bank and very little concrete action. And as long as the talk is sufficient to keep fear in check that inaction is positive for the euro.
Of course, events might not cooperate with politicians’ desires to do as little as possible. In Spain the continued retreat of real estate prices and the increasing inability of Spanish borrowers to pay (strange how not having a job makes it harder to keep up with the mortgage) keeps adding to the bad loan problem at the country’s banks. In Italy the February elections could produce political deadlock or worse. (Not surely another Berlusconi government?) Events in either country could force EuroZone politicians into action and create, first, enough fear to send the euro back down, and second, some stimulus from the European Central Bank that closes the gap with the Fed and the Bank of Japan. And that would be enough to slow—if not reverse—the tide now flowing in the direction of the euro.
All of which makes it hard to project how long the tide will flow in the current direction. I’d say at least until the U.S. stumbles its way to some kind of deal on the fiscal cliff and the debt ceiling. And until the Bank of Japan and the new Japanese government reach some kind of accommodation. And until the February elections in Italy prove really dysfunctional.
The flows could continue in the euro’s direction for longer than that if U.S. negotiations break down for long enough to lead to a downgrade of the U.S. credit rating. Or if the Bank of Japan caves into the new government and starts to stimulate at the high level needed to get inflation to 2%. Or if Berlusconi throws his support back to Mario Monti’s technocrats and the February elections in Italy restore the status quo.
I’ve mentioned the effect of a strong euro/weak yen-dollar tide on improving sales for weak currency exporters and improving quarterly earnings for Japanese and U.S. companies that will translate stronger sales in stronger euros back into weaker yen and dollars. And I’ve mentioned the way that a weaker dollar would push up the prices of commodities such as oil, copper, and gold.
But the biggest effect will be on global cash flows into commodity economies and emerging markets. Low interest rates in the United States and Japan and a reasonably reliable expectation that the yen and the dollar will continue to slide (even if only slightly) will power a carry trade that will send hot money into financial assets into countries such as China, Brazil, and Australia. Look at the interest rate differentials: The benchmark short-term interest rate is at 0% to 0.25% in the United States and Japan—and at 3% in Australia, 7.25% in Brazil, and 6% in China. If you can borrow at corresponding low rates in the United States and Japan, and then invest at corresponding high rates in Australia, Brazil or China, who wouldn’t. Especially if the currency trend is flowing against the yen and the dollar so that you’re likely to have to pay your loans back tomorrow in yen and dollars that are worth less than they are today.
There’s some evidence that we’re already seeing fast money flows into Hong Kong—Hong Kong’s Hang Seng Index is up 17.7% since the September 5 low and 6.8% from last month’s low on November 15. And it looks like China’s government is interested in capturing more of that overseas hot money for its Hong Kong and Shanghai markets. On December 13 the head of the Hong Kong Monetary Authority said that China may relax or abolish rules that require the biggest of overseas investors to keep most of their money in bonds. On December 14 China did abolish the current $1 billion ceiling for investments from sovereign wealth funds and overseas central banks.
How long countries such as China and Brazil will welcome these hot money flows is an open question. These cash flows push up the price of local currencies—even very gradually in China—which takes a competitive bite out of local exports. At some point that damage to local business is enough to produce interventions in the currency markets with countries selling reserves of their own currencies in the markets in an effort to drive down the price. For example, Brazil has already warned the United States that the Fed’s new round of quantitative easing risks a renewal of global currency wars. Beginning in 2010 Brazil has used measures to control the appreciation of the real whenever its strength sufficiently threatened Brazilian exports. The real ended last week at 2.086 to the dollar. That’s roughly a third below the currency’s July 2011 peak of 1.52 to the dollar.
This is why the question of how long and strong the tide runs in the euro’s favor is critical to determining the effect of a stronger euro and weaker yen/dollar. If the move looks like it is temporary and likely not to run much further, I think countries like Brazil and China will take only minimal steps to protect their exports. Without those steps the strong euro is a tide that is likely to lift the prices of financial assets in those markets—and in commodity economies such as Australia and Canada. But if the tide shows no signs of moderation by, say, February, then I think we could see moves by developing economies that would aim to weaken their own currencies to keep up with a falling yen/dollar.
That would add significant cross-currents to global cash flows and make it much harder for investors to figure out exactly how the currency tides toward the euro and away from the yen/dollar will play out in the prices of global stocks and bonds.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did now own the shares of any company mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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