King Dollar and the Eurozone
Financial Review
Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)
DOW – 115 = 16,544
SPX – 22 = 1906
NAS – 102 = 4276
10 YR YLD – .02 = 2.30%
OIL – .25 = 85.52
GOLD – .60 = 1224.00
SILV + .05 = 17.50
The 10 year German bund has a yield that is 141 basis points lower than the US 10 year Treasury note. The yield on German debt will get you 0.89%. Standard & Poor’s lowered France’s credit outlook today, and you can still get a 10 year French note with a yield of 1.25%. A 10 year note from Spain will only get you 2.06%. Is this because the US debt is riskier than the Spanish debt? No, just the opposite.
The problem in the Eurozone is deflation, and it threatens to bring the economy to a grinding halt, and send the EU into a triple dip recession. The president of the European Central Bank, Mario Draghi, gave no indication of any further monetary stimulus beyond what was announced this summer, suggesting in a speech in Washington that governments needed to do more on the fiscal side. Draghi said in effect that Eurozone countries that have enough money should spend it, a clear reference to Germany. His comments echoed remarks this week from Christine Lagarde, the head of the International Monetary Fund.
Today, German Chancellor Angela Merkel said her government was examining how to encourage investment, particularly in the “digital sphere” and the energy sector. Merkel did not elaborate, but the hint was that Germany might use government spending to stimulate growth, a possible shift in position that could ripple across the entire Eurozone. Merkel’s remarks may have been less a declaration of policy change than a signal that her thinking on stimulus was evolving.
On Wednesday, the Federal Reserve released minutes from the September FOMC meeting, and they expressed concern about the global economy and the dollar. In the past 4 months the dollar has jumped about 8% versus the euro; that kind of swing can prove a threat to trade and to financial markets. The Fed normally focuses on the US economy, unless there are global developments that are important enough that they could intrude. Fed officials pointed with concern to the slowdown in China, Europe and Japan. They also worried that the concurrent strengthening of the dollar would add to the risk of price deflation.
We know that a strong dollar could weaken US export performance and hold back growth, but the recent global slowdown represents a more ominous problem. Global economic weakness would undermine the ability of the Fed to maintain financial asset prices well above the levels strictly warranted by the fundamentals. Of course this has been how the Fed has addressed the crisis and the recovery for the past 6 years, they pumped up Wall Street with easy money. A global slowdown threatens that tactic.
The events of the past week indicate the Eurozone and especially Germany might be closer to a move away from the single minded focus on budget austerity that has, to date been an absolute failure. The bigger question is whether the Eurozone countries and the ECB will take action, and if they can actually do anything before the continent slips into full-fledged deflation; and further, what role that might mean for the Federal Reserve.
Finance ministers and central bankers gathered in Washington for the annual meetings of the World Bank and International Monetary Fund and today, Treasury Secretary Jack Lew urged the Group of 20 major economies to refrain from competitive currency devaluations. Federal Reserve officials are hunting for new tactics to raise price increases to their target as slowing global growth, cheaper commodities and flat wages sound warnings that inflation is descending toward the danger zone.
With inflation at 1.5% according to the Fed’s preferred index, low-flation is getting to be a real issue again. We know a stronger dollar makes US exports overseas less affordable, but a strong dollar makes it cheaper for Americans to pay for imported goods. A 10% increase in the dollar versus currencies of major trading partners could trim inflation by a quarter percentage point, and the Fed has not yet communicated a plan for how they will lift inflation to their desired target of 2%.
An inflation rate approaching zero is bad for the economy because of its impact on behavior by businesses and consumers. Companies’ inability to raise prices hurts profits, and they rarely compensate by cutting wages, so they fire workers instead. Consumers anticipating falling prices may postpone discretionary purchases. This can combine to create a vicious circle of less spending and further downward pressure on prices. Think about your own situation; in the past couple of weeks you’ve seen prices at the pump drop. Were you tempted to drive another day or two before you fill up the tank in the hope that you might save a few pennies per gallon?
And what we are seeing in the Eurozone is that once low-flation becomes deflation, the central bankers don’t really have the tools to deal with the problem. It is known as pushing on a string. They can flood the markets with easy money, but they can’t create demand, because, you know, prices will be lower next week. As we are seeing in the Eurozone, and as we saw in Japan, if you let it go on for too long it becomes a lock-in, it reinforces a bad outcome.
Substantial rallies in the dollar have the power to slam the brakes on GDP growth in a way that Fed tightening even doesn’t. GDP growth could decline by a percentage point if the rapid move in the dollar continues through early 2015. That fall in GDP is even larger than what would occur as a result of a 50-basis-point rise in long-term interest rates, and it works with a lag, too. Even when the dollar rally tapers off, it would be expected to constrain GDP through early 2016.
And for now at least, you might reasonably expect the dollar rally to continue; there is a trend in place. The long dollar bets mean money is being parked in the US, and that means continued downward pressure on long-term interest rates, at least for now. And another thing, when there are very rapid and pronounced changes in the exchange rate there is a tendency for investors to lock in gains from previously accumulated US assets. In other words, there is a tendency to sell stocks, and companies with overseas exposure are more likely to experience a greater decline. And the selloff in stocks is yet another hit to US GDP. It’s a nasty cycle.
On Wall Street, stocks closed out a volatile week with another triple digit loss for the Dow, giving the market the worst week since May 2012. The Dow industrials have now turned negative year to date. Yes, that was fast. The Dow lost 2.7% for the week. The S&P 500 dropped 3.1% on the week. The VIX, the volatility index jumped 45% for the week. The Stoxx Europe 600, Europe’s benchmark stock index posted its biggest slide in 2 years, down 4.1% for the week. The S&P 500 is sitting right at its 200 day moving average. The Dow Industrial dropped below the 200 day moving average, about 40 points lower.
A moving average is simply an average of a certain number of data points. The 200-day moving average is calculated by summing the past 200 days and dividing the result by 200. The 200-day moving average represents the average price over the past 40 weeks. This helps to smooth out day to day volatility and give a longer-term look at the overall trend. The 200 day moving average is considered a very important level of resistance or support; in this case, support. When a stock or an index breaks down below this key level of support you sometimes see a bounce, because there will be some investors who think they are now able to buy stocks cheap. But the bounce can sometimes be misleading; that’s known as a dead cat bounce. If dropped from high enough, even a dead cat will bounce. So the next few days will be critical to see if the markets can bounce, and if they can bounce, will they rally, or will prices just keep falling from here. If we don’t see a turnaround, it would confirm a downward trend.
This week the Nobel Committee handed out prizes for a better lightbulb, the LED; a better microscope, that sees nanoparticles; and a French author that I had never heard of. Today, Malala Yousafzai and Kailash Satyarthi have won the Nobel Peace prize. If you have not heard the story of Malala or heard her speak, you should; she will inspire you. She is the daughter of a teacher, and she grew up in and around schools, at least until 2008, when the Taliban took control of the Swat region of Pakistan, where she lived. The Taliban tried to close down schools for girls. That year, her father took her to Peshawar where she made a speech in front of national press titled “How Dare the Taliban Take Away My Basic Right to Education?” She was only 11 years old. In early 2009, Malala started blogging anonymously for the BBC about what it was like to live under the Taliban.
Two years ago, armed men boarded the converted truck that Malala and her classmates used as a makeshift school bus and they shot Malala in the head. She survived. Nine months after she was shot, Malala gave a now famous speech at the UN, where she said: “They thought that bullets would silence us. But they failed.” She’s continued her high-profile campaign for girls’ education with The Malala Fund, which raises money to promote girls’ education.
At 17, Malala is the youngest winner of the Nobel Peace prize, which she will share with 60 year old Kailash Sayarthi. In 1980 Satyarthi founded the Save the Childhood Movement, and he has helped rescue more than 80,000 children from bondage, trafficking and exploitative labor in the past three decades; he also spearheaded a movement to make free and compulsory education a constitutional right for children in India in 2009.
The Nobel committee said it “regards it as an important point for a Hindu and a Muslim, an Indian and a Pakistani, to join in a common struggle for education and against extremism”.
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