Currencies in a Race to Debase

Economic Data - Previous Week
Date Series Actual Forecast Prior
3/19 Housing Starts 0.8% 2.8% -7.3% Partial comeback from Jan slide; sizeable gain in permits
3/21 Philadelphia Fed 2.0 -3.0 -12.5 Modest growth after steep contraction in January
3/21 Existing Home Sales 0.8% 1.6% 0.8% Sales accelerate as higher prices bring more supply to market
3/21 Leading Indicators 0.5% 0.4% 0.5% Steady growth with broad-based gains among components
Economic Data - Upcoming Week
Date Series Actual Forecast Prior
3/26 Durable Goods Orders -- 3.9% -4.9% Bounce expected after plunge in January transport orders
3/26 Case-Shiller Home Price -- 0.78% 0.88% Prices continue to climb; slight moderation in acceleration rate
3/26 Consumer Confidence -- 67.5 69.6 Further weakness likely as consumers adjust to payroll tax hike
3/26 New Home Sales -- -3.9% 15.6% Sales growth to slow, normalizing after robust gain in January
3/27 Pending Home Sales -- -0.4% 4.5% Sales expected to dip as inventories remain depressed
3/28 4Q GDP (3rd Est) -- 0.5% 0.1% Sizeable revision expected on better exports & domestic sales
3/28 Chicago PMI -- 56.5 56.8 New orders strength to moderate after February's rise
3/29 Personal Income -- 0.9% -3.6% Rebound from Jan decline expected on improving jobs mkt
3/29 U. of Mich Confidence -- 72.7 71.8 Confidence expected to rise on improved expectations
Source: Bloomberg

Cyprus Rattles Markets

European concerns rattled US equity markets last week, leading to marginal losses for the period. The S&P 500 shed 0.2%, while the Dow Jones Industrial Average finished flat.

The tiny country of Cyprus roiled global financial markets last week as the nation’s banking system threatened to collapse. An initial proposal to levy a tax on Cypriot bank deposits caused an uproar domestically and was ultimately vetoed by legislators. The proposal’s dismissal, however, endangered a bailout proposed by the European Union. Cyprus’ banks remained closed throughout the week to prevent potential bank runs.

Over the weekend, Cypriot officials met with their EU counterparts in Brussels in a frantic attempt to save the banking system. Reports indicated that a tentative deal had been reached to impose a 20% levy on all deposits over €100,000 at the nation’s largest bank, Bank of Cyprus, although that had not yet been confirmed by major media outlets.

Although Cyprus represents just 0.2% of the Eurozone’s GDP, investors have been rattled by the sudden insolvency of the country’s banking system. That is because Cyprus’ banking sector accounts for approximately €126.4 billion, which is seven times the size of the country’s economic output. It is estimated that Cyprus needs €17 billion in support to keeps its oversized banking sector afloat. The European Union has imposed a Monday deadline for reaching a resolution for the country.

The week’s other economic news surrounded the Federal Open Market Committee (FOMC) meeting which occurred on Tuesday and Wednesday. In a statement on Wednesday, the FOMC remained committed to its previous policy stance. This included $85 billion in asset purchases per month, the reinvestment of principal from maturing securities, and maintaining rates near zero as long as unemployment is above 6.5% and inflation does not exceed 2.5%. All FOMC members except Esther George voted in favor of the policy action.

The committee’s statement acknowledged generally improved economic conditions following a “pause” in the fourth quarter. In Ben Bernanke’s press conference following the meeting, he echoed this sentiment in saying, "the data since our January meeting have been generally consistent with our expectation that the fourth-quarter pause in the recovery would prove temporary and that moderate economic growth would resume." Mr. Bernanke also noted that the group did not see any major risk to the US economy or financial system from the situation in Cyprus.

Economic data was generally positive in a slow week for data. On the housing front, the Census Bureau reported that housing starts improved from 910,000 to 917,000 in February. The prior month’s data was also revised higher by 20,000.

Starts experienced positive momentum in both the multi-family and single-family components of the series. The more striking feature of the report, however, was a strong uptick in building permits. At 946,000, permits surpassed expectations by more than 20,000 units during the month. This suggests strong forward momentum entering the Spring and Summer months.

In other housing news, existing home sales improved by 0.8% in February to a rate of 4.98 million sales. This was 10.2% above year-ago levels, and the highest since February 2009, a period boosted by the government’s tax credit stimulus.

Interestingly, housing supply rose in February following several months of contraction. Economists had generally pointed to the falling supply as a headwind for continued sales improvements. However, at 4.7 months of supply, the stock of homes for sale is still 19% below levels observed 12 months earlier.

The proportion of distressed transactions increased modestly to 25% in February, from 23% the month before. This reading has gradually improved, though, down from 34% one year ago. Distressed homes (foreclosures, short sales) generally sell for below market prices and weigh on the broader housing market. Despite the increase in distressed property sales, the housing market appears to be experiencing positive momentum on several fronts, and should remain a driver of economic growth in the quarters ahead.

Finally, the manufacturing sector received another piece of good news when the Philadelphia Fed Survey reported its General Business Conditions Index bounced back from negative territory in March. At 2.0, the index jumped 14.5 points from the prior month, boosted by gains in new orders, employment, and shipments. This month’s gain is a positive development for a report that had generally been inconsistent with the headline ISM Manufacturing index, which has seen positive advances in recent months.

Currencies in a race to debase

Since the start of the year, investors have seen rapid shifts of sentiment in currency markets. The debasement that for so long was assumed to be a purely Western phenomenon is beginning to impact countries globally, driving changes in expected returns and growth prospects.

The most obvious example of this phenomenon is Japan, where the election of Shinzo Abe led to broad speculation that the new government would take drastic measures to reach a 2% annual inflation target. Since rumor of these measures started circulating around the marketplace, the Yen has fallen 20% against the dollar.

Yen/US Dollar Exchange Rate:

Source: Federal Reserve Bank of St. Louis

The euro represents another currency under attack, albeit for far different reasons. At the start of the year, the Euro traded at $1.32 relative to the dollar. After rallying during the first half of the quarter, the Euro has recently reversed lower as the continent’s debt crisis fears resurfaced. At the end of last week, the Euro was trading at $1.30, below where it started the year, with expectations for further declines.

US Dollar/Euro Exchange Rate:

Source: Federal Reserve Bank of St. Louis

In Britain, the US Dollar/British Pound cross-rate moved below $1.5 for the first time since mid-2010. Britain’s austerity measures, along with structural economic problems, continue to be a drag on economic growth, driving a 0.3% contraction in fourth quarter GDP. The recent announcement that Mark Carney would take over as governor of the Bank of England in July leads many strategists to conclude that he will pursue more aggressive monetary policy actions going forward in targeting economic improvements.

US Dollar/British Pound Exchange Rate:

Source: Federal Reserve Bank of St. Louis

In the universe of currency majors, this leaves only the US Dollar as a bastion of strength. Since the start of the year, the trade weighted US Dollar Index is up from 73 to 76. The last time the trade weighted index was at 76 was mid-2010. On a relative basis, economic conditions in the US are reasonably healthy, monetary policy is closer to tightening than further easing, and traders have few other choices to invest money.

Trade Weighted US Dollar Index:

Source: Federal Reserve Bank of St. Louis

What does all of this mean? For investors, the results have been noticeable. Japan’s Nikkei is higher by almost 19% YTD, currency traders are experiencing their best performance in several years given the broad opportunity set, and risks to investing internationally have increased significantly.

In this environment of currency debasement, certain economies are likely to suffer – most notably in the emerging markets. The era of ultra-loose monetary policy in the developed world is likely to spill over into emerging market economies in the form of higher inflation, wages, and potential instability. The impacts across emerging market economies will likely be uneven, particularly given the monetary flexibility in countries such as Brazil, but the money printing experiment occurring globally is one with increasingly dangerous unintended consequences.

Currency markets are likely to remain a robust trading opportunity this year, as the direction of economic performance and central bank policy begin to diverge. The somewhat benign conditions experienced in currency markets over the past several years are likely coming to an end, and investors should pay close attention to the next big move in the “race to debase.”

The Week Ahead

Following a slow week, a spate of new economic data is due out in the coming days. The first quarter closes out with information on durable goods, new home sales, and personal income & outlays. On Thursday, the final estimate of fourth quarter GDP is released by the Bureau of Economic Analysis.

Several central banks release updated policy this week, including Uruguay, Turkey, Hungary, Romania, Taiwan, and the Czech Republic. Hungary is expected to cut rates.

The information provided is general in nature and is not intended to be, and should not be construed as, investment, legal or tax advice. Fortigent makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of, or reliance on, the information. The information is subject to change and, although based upon information that Fortigent considers reliable, is not guaranteed as to accuracy or completeness.

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