The response of the currency markets to the civil war in Libya and the more the 10% rise in the price of oil in less than two weeks has been markedly different than that of the bond and equity markets. Currency traders seem to think that the effects of the oil spike on the world economies will be transitory. They have given little credence to the increased risk of an economic slowdown or recession in the US or elsewhere. Consequently risk appetite and the euro have gained. Their brethren in the stock and credit markets, however, are far more cautious.
The equity markets have just had their longest sustained negative run this year. Profit-taking on the recent powerful rally is only one reason for the selling. Downward adjustment to economic growth expectation is another.
The Federal Reserve has amply demonstrated its conviction that low rates are necessary to support a weak economy. The yield of the US 10-year Treasury has fallen almost 30 basis points since February 8th as the credit markets anticipate Fed pressure on rates and the effective permanence of its zero rate policy. US statistics have been strong but the credit markets are reacting to the economic stress coming from sustained higher oil prices. Tempting as it might be to ascribe the recent dollar fall the decline in Treasury rates it would be incorrect.
The normal correlation between Treasury rates as the leading edge of Federal Reserve policy and movement in the dollar has been broken since the financial crisis. Just a recent example from many: from April to October last year yield on the 10-year Treasury dropped from 4.0% to 2.4%. During that time the dollar rose against the euro from April to June (1.3500 to 1.1950) and then turned around and fell until October (1.1950 to 1.3935). Treasury yields are not driving dollar trading.
The current pro-Euro consensus is due to several non-financial EMU factors
- Strong German economic growth and statistics especially the recent Ifo, ZEW and PMI numbers
- ECB hawkish inflation comments, though there is also an element of the campaign for the ECB presidency in the comments
- The Fed focus on QE and unemployment. No one thinks the Fed will raise rates. Even if the same is true of the ECB, European hawkish talk is just that, at least they are saying something. The Fed seems unconcerned about domestic or international inflation.
What is being ignored in this pro-euro consensus?
- The events in the Middle East have been so rapid that their damaging effects are not in the statistics-but they will be soon.
- Risk aversion and safe haven flow are evident in other markets. Gold, the Japanese Yen, the Canadian Dollar and the Australian Dollar are at or near records
- The effects of American tax cuts and government spending are already waning, QE2 ends in four months.
- The political changes in North Africa are permanent. The new governments will be far less interested in the economic status quo. Change will come soon and it will be as disruptive of economic arrangements as it has already been of political structures.
- China's attempt to slow its economy will bear fruit and combined with the disruption inflicted by oil, assumptions for world economic growth will be adjusted down.
So far the currency markets are betting that the effects of the oil price increase and the increase itself will pass without much notice, and that there will be little damage to the underlying world economic recovery. The smaller factors of good German economic statistics and hawkish ECB inflation commentary have been enough to keep the euro on the upswing.
But higher oil prices will not be transitory because the situation which produced them is not transitory. The result of these higher prices must be slower worldwide economic growth, particularly in countries as the United States where a large percentage of GDP is dependent on the consumer.
The rapid rise in equities since last December has cloaked the world in good feeling. But the economic underpinnings of the world recovery remain fragile. They will be severely tested by the economic effects of the revolutions in North Africa. The safe haven trade to the US dollar is not yet dead.
Chief Market Analyst