(photo credit: Bloomberg)
No major financial market generates as much frustration and perplexity as the foreign-exchange market, and it’s not hard to understand why. Take the last few days as a prime example: A series of negative developments relating to the state of the US economy – which included a downbeat assessment from the Federal Reserve Board, as well as shockingly bad trade data for June – made it crystal clear that the economy is sliding downhill. The rate of GDP growth in the second quarter, the first estimate of which was a less-than-forecast 2.4 percent, will therefore be marked downward in upcoming revisions, by between 1%-1.5%. The outlook for the second half of the year is accordingly bleaker.
You would think that all this bad news would feed straight into weakness
for the dollar on global markets; in fact, continued weakness, because
the dollar has been falling for some time. But you would be wrong: The
dollar has been rising all week, and it jumped especially sharply on
Wednesday, after the trade data were published.
If the picture regarding growth in the American economy has been
disappointing, then that of the Japanese economy has been even worse.
Last week’s column noted some of the long-term factors at work in
undermining the Japanese economy, while the short-term data show that
the rebound from the recession of 2008-09 has run out of steam. Given
this sorry state of affairs – compounded by Japan’s zero interest rate
and long-term government bonds that give much lower returns than those
of the US and large European economies – one would not expect the
Japanese yen to hit a 15-year high against the dollar this week, as well
as continuing its relentless rise against European and other
currencies. But that’s exactly what happened.
Further examples are available but unnecessary. To compound the problem,
there are also cases where a slew of negative economic news is followed
by a decline in the country’s currency, in line with “economic logic”
and “common sense.” The UK and the pound sterling provided a case in
point of this nature, also this past week.
So what gives? One possible explanation, offered to me by a long-time
banker who has seen the markets at work over several decades, is
brutally simple and cynical: The markets – including even the biggest of
them all, namely the global foreign-exchange market – are
systematically manipulated by a shadowy group of big players. These are
banks and brokerages whose main interest is that there be movement and
activity in the market, irrespective of which way prices actually go.
Consequently, prices are pushed or channeled first in one direction and
then in the other, unconnected to daily or short-term news and often
seemingly unconnected even over long periods of time to “underlying
This approach is the diametric opposite to the idea, beloved of
academics and textbooks, that markets in general and, perhaps
especially, the largest, most-liquid and most-sophisticated market of
all, the foreign-exchange market, trade on the basis of available
information and rational expectations arising from that information.
Unfortunately, as noted above, it’s all too easy to show that short-term
movements in this and other markets are often entirely unrelated to the
flow of information reaching the market and to the expectations that
might rationally be derived therefrom.
But it is also impossible to accept that the market moves are the result
of random, almost arbitrary, manipulation.
The sharp fall in the euro and other European currencies versus the
dollar and other non-European currencies began last November and
continued until early June. It was driven not by anonymous-but-powerful
speculators but by the crisis in confidence about Europe, the European
Union and several countries within it. This crisis began with the
revelation that Greece was in dire straits and quickly morphed into a
much wider panic.
But the massive support package, worth in excess of $1 trillion, cobbled
together by the EU and the IMF and awarded to the PIGS countries in
May, eventually caused sentiment to change, at least temporarily. From a
low of below $1.19 per euro in early June, the euro recovered to $1.33 a
week ago. That recovery seems now to have ended, and the primary trend
of dollar strength and euro weakness has reasserted itself.
Why that is happening when the US economy is getting weaker (and Germany
looking good) seems very strange. But the parallel strength of the yen,
which represents an even weaker economy, provides a clue for an
explanation. The latest data from the US and from China show that in
both countries – the respective leaders of the developed and developing
worlds – the pace of recovery is flagging and the economy is heading
south. That is bad news for them, but even more so for a world that is
increasingly dependent on these two now-sputtering engines.
The response of players in all the financial markets is to sell risky
assets and move to assets viewed as not, or at least less, risky. These
include the dollar, US government bonds, the Japanese yen, the Swiss
franc and Swiss government bonds – and that’s about the end of the list.
Why these are considered safe, and whether and to what extent that
perception is well-founded, is another matter. But for the moment at
least, that is how the markets view things. And that is why weakness in
the American economy has generated the unlikely and counter-intuitive
result of strength in the American dollar.