On the 20th anniversary of Black Monday last month, there was much prognostication and opining from soi-disant market sages. Comparisons between equity markets then and now are wide of the mark. However, wind the clock forward five years from 1987 and look at currencies rather than equities and the parallels are compelling.
The last time before this year that the DXY index, which measures the strength of the dollar against a basket of other currencies, fell below 80 was September 1992. Germany was experiencing a post-unification boom and the US was fighting a recession. On Black Wednesday (September 16) both the pound and the Italian lira fell victim to the mighty Deutschemark and were forced out of the European Exchange Rate Mechanism.
We are now living through another period of profound currency market misalignment.
At the root of most of the evils are global imbalances. The US current account deficit is 5.5% of GDP. At the same time, Asian economies, most dramatically China, are accumulating foreign exchange reserves. China had reserves of just $50 billion in 1994. Today, they are more than $1 trillion.
China’s mercantilist economic policy keeps the value of the yuan artificially low. The resulting current account surplus is recycled back into dollar assets. This excess of (uneconomic) saving brings with it the risk of asset bubbles by artificially keeping US interest rates low.
Policymakers have a long track record of saying nothing about currencies and doing less. The G7 communiqué last month was a classic of the genre – the silence was deafening. But sooner or later the distortions created by global imbalances must be addressed. The only question is whether this unfolds in a benign and controlled way or in a manner that endangers financial stability and the world economy. Those risks are real.
The biggest danger is that the weakening dollar becomes self-reinforcing. US retail investors are voting with their feet, buying global stock funds at a record pace of $12 billion a month according to Lipper, a division of Reuters. Remarkably, in spite of a strongly performing US market, the dollar amount invested in domestic stocks by retail investors has not increased at all since 2003.
Suppose sovereign wealth funds and central banks were to follow suit? A weak currency buoys up returns when US investors buy overseas. It is harder to justify an investment in dollars that exposes the holder to losses. Any wave of selling is likely to drive prices even further out of kilter, which is in no one’s interest. However, there are signs that the demand for US assets among foreign central banks has reached saturation point.
So far this year the Federal Reserve’s custody holdings rose by 13%. That compares with a 15% increase in 2006 and increases of 24.5% in 2004 and 25.4% in 2003. Markets had a nasty shock last month when the US Treasury revealed that fund flows into the US were negative in the month of August for the first time in nine years. The outflow of $69.3 billion was three times the previous record.
A horror-show could unfold in which a falling dollar causes the selling of US assets or a buyers’ strike at a time when the US needs $2 billion a day to fund its current account deficit. The Federal Reserve could be forced to keep interest rates artificially high to attract foreign capital just as the economy is at a tipping point between a slowdown in growth and a full-blown recession.
The so far untested idea that the global economy can decouple from the US in 2008 would be out of the window at euro/dollar $1.50 and dollar/yen at ¥100. Dollar pegs across the world would come under concerted attack.
The unwinding of global imbalances need not take the world to the brink of economic catastrophe. US exporters are already benefiting from their enfeebled currency. The US current account deficit is falling and is on course to be below 5% of GDP in the first half of next year. Once the credit markets begin functioning properly again, US companies will be attractive M&A targets.
The dollar does not need to weaken further for imbalances to be corrected. To keep this process on track, politicians need to do more, in thought and deed. They should talk up the dollar and back that with coordinated intervention, buying dollars at pre-agreed rates against the euro and yen.
The current vogue is to dismiss gyrating currency markets as the plaything of City spivs. Any politician who believes this would do well to look back to 1992. Two months after the DXY index hit its cyclical low point, George H W Bush was defeated in the presidential election by Bill Clinton.
John Major’s UK government lost its reputation for economic competence on Black Wednesday and the result has been the longest-ever Labour administration in UK history. Neglect is not a substitute for policy. Markets have a nasty habit of overshooting. A dollar rout could precipitate an economic crisis the world and its political leaders can ill afford.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.