2010 Review/2011 Outlook Part II of I
11/Jan/2011 • Currency Updates•
We start the second and last part of this series by summarizing the four key issues that have driven and (we expect) will continue to drive FX markets.
- The crisis buffeting the weaker Eurozone sovereigns: Greece, Ireland, Portugal, Spain, and potentially even Italy and Belgium.
- The second round of Large Scale Asset Purchases by the Federal Reserve, the potential for the Bank of England to follow through, and the gap that is widening among different monetary authorities and their responses to the crisis.
- The continuing macroeconomic unbalances between “saver” countries, i.e., those with persistent trade surpluses (particularly Pacific Asia and Northern Europe) and “spender” countries, particularly the United States and (to a lesser and diminishing extent) Mediterranean Europe.
- The end of fiscal stimulus in developed economies, to be replaced in some countries (notably, the United Kingdom and the troubled sovereigns of the Eurozone) by a significant fiscal drag brought about by draconian austerity measures.
To repeat, the most notable feature of the global financial landscape remains the lack of resolution in any of these critical issues. The absence of any sense of global coordination (so critical in stopping the downward slide in 2009) adds more uncertainty to the mix, and makes it even less likely that any of these problems will be resolved without a high degree of market volatility. We therefore expect 2011 to be a tumultuous year, one in which at least some of the global contradictions described above will be resolved for better or worse. What follows is our best guesses as to the developments an FX investor can expect in each of these defining themes for 2011.
The European crisis is nowhere near being resolved. Ireland and Greece have already given up on funding themselves in the markets, and have tapped IMF and Euro-wide bailout funds. It is doubtful whether Portugal can issue bonds to private investors in any significant size. At any rate, current yields of nearly 7% are not economically sustainable, so it is likely that it will soon ask for EFSF funds. Whether or not Portugal is bailed out in 2011 obscures a more important point, in our view. Neither Greece nor Ireland is currently financially viable. The combination of draconian austerity measures, very high real interest costs charged through the bailout facility and refusal to entertain the notion of any haircut on either sovereign or bank debt means that both countries are liquid but insolvent. This contradiction must be resolved through either a significant change in the bailout terms (particularly the interest charged) or a debt restructuring. We remain agnostic on which resolution will actually take place, but adamant that it must be one or the other.
That said, Greece, Ireland and Portugal are small enough that either of the above solutions would be manageable for any and all of them, from the viewpoint of the future of the common currency. Not so Spain. The size of its foreign indebtedness, public and private, is about 1 trillion Euros, most of it owned to core European banks. A Spanish debt restructuring would almost certainly mean the end of the European monetary experiment. Furthermore, the true state of the Spanish banking system, as well as the cost of cleaning up the damage caused by the Spanish real estate bubble, remains shrouded in opacity and equivocation.
If we rule out the possibility of a Eurozone break up, there are two ways in which these problems can be dealt with. One would be for policymakers to allow the ECB to continue to underwrite the European banking system and expand its purchases of distressed sovereign bonds on an ad-hoc basis. This would be a clear negative both for the euro and the European economy. A more desirable scenario would be for European policymakers to develop a credible Euro-wide fiscal union to complement its monetary one. It would entail explicit fiscal transfer mechanisms between countries, some sort of common sovereign Eurobond instrument, and, critically, bailout packages under conditions that ensure economic viability for the countries receiving them. We consider this later scenario quite unlikely in the near term. Given the heavy issuance needs of peripheral countries in early 2011, we believe that the former solution is likely to be employed and maintain a pessimistic view of the prospect for the European currency.
The second factor that will be key during 2011 is the evolution of the Large Scale Asset Purchases (LSAP) program launched by the Federal Reserve in November,the possibility of an increase in the quantitative easing policy by the Bank of England, as well as the misalignments that these policies have brought about in some of the other G10 economies. Both the Fed and the Bank of England have made it clear that they intend to maintain an aggressive stance, albeit for somewhat different reasons. In the case of the Fed, it is because of the explicit mandate that it has to maintain full employment as well as price stability, somewhat exceptional among central banks. The BoE, because of fears about the macroeconomic impact of the massive fiscal tightening that the coalition Government is implementing, which (as has been leaked recently) was quietly pushed by BoE leadership all along.
The decision on whether to halt or increase the balance sheets of the Fed and the BoE have had and will continue to have a major impact in financial markets.This is not only because of the direct downward pressure on their respective currencies and government bond yields effected by the purchases, but also because central banks around the world are pressured to maintain easier monetary policies than is warranted by their domestic economies.
Switzerland, Canada, Scandinavia, and Australia are experiencing relatively thriving domestic demand; buoyant housing markets, propelled by the extremely low interests rates prevailing (except in Australia); and robust export sectors. Yet their interest rates are very low, and markets are discounting very little additional tightening. A strengthening currency is a poor substitute for rate normalization, as it disproportionality affects the export sector, actually strengthens domestic demand, and has no impact in the housing market. We expect that the complacency in these countries will not last long, and most G10 central banks outside the major currencies will surprise to the upside in terms of rate hikes.
Overall, we think that the market is pricing roughly fairly the size of the second LSAP out of the Fed, but is underestimating the chances of additional easing by the BoE and the chances of rate hikes in Switzerland, Canada, Sweden and Norway.
The rebalancing of the global economy remains inevitable thought it is clear that it will be carried out in an uncoordinated, haphazard manner prone to numerous financial and political accidents along the way. It must be remarked that, since the trade deficits of the weaker European sovereigns are very quickly closing already, “global rebalancing” is now essentially a euphemism for a lower US trade deficit. We think this issue, which has seceded somewhat from the financial scene recently, will again dominate discussions later in the year for two primary reasons:
- US consumption indicators are generally rebounding faster than either production or exports, and therefore the considerable progress that had been made during the crisis in correcting the US trade deficit is now starting to be undone. There is no indication whatsoever that US authorities are concerned by this return to a consumption-based economy – rather the opposite; it is being welcomed and encouraged.
- The balance of payments position of the US tells a worrisome story. The halving of the US current account deficit from roughly 6% of GDP to just 3% has distracted attention away from the way in which this deficit is funded. But while the funding requirements have fallen, the quality of this funding has become remarkably poor. Official investors (foreign central banks and reserve managers) now fund 80% or so of the US current account deficit. This is all the more worrisome when the US is actively discouraging intervention, and thus official financing, while the extremely low yields offered by US fixed income instruments are not sufficient to attract private investors.
All of these unresolved issues regarding the US dollar make it hard to be positive on the long term prospects of the greenback, even if we expect the resolution of the Eurozone crisis to be a much more important FX driver in the near term.
The final risk factor for economies and financial markets, and one that is particularly relevant for the United Kingdom is the upcoming economic drag from fiscal tightening. The world has never experienced a simultaneous fiscal retrenching of the kind that is now approaching. Further, the ability of many of the G10 economies to develop self-sustaining economic recoveries to compensate for the loss of fiscal stimuli is not clear. Finally, there is a complacent expectation that continued monetary looseness will compensate for the fiscal cuts: we are much less sanguine, as rates have been at or near zero for a long time already and therefore we do not expect the continuation or even the expansion of monetary easing policies to have much marginal effect.
Particularly at risk here are the countries where the planned fiscal cuts are truly draconian. The United Kingdom stands out, as do the weaker Eurozone sovereigns. The example of Ireland is particularly sobering: the Irish have been relentlessly cutting Government spending for two years, but the economy has shrunk so fast that the deficit has actually worsened. In contrast, the relative lack of concern with deficits prevailing in the United States could be an unexpected positive for the US currency in the coming year.
While we do not have a crystal ball (unfortunately) we hope this two-part series has helped you in clarifying the issues and events that will drive financial markets in 2011. Good luck everyone!