The dramatic shifts on currency markets over the past few weeks have decisively signalled the end of one chapter in the story that began on 9 August last year and the start of a new one. Specifically, the theory of global economic decoupling is being expl
The dramatic shifts on currency markets over the past few weeks have decisively signalled the end of one chapter in the story that began on 9 August last year and the start of a new one.
Specifically, the theory of global economic decoupling is being exploded – that is, the idea that this is a US problem only and that the effect on the real economy of sub-prime mortgage defaults and bank losses will be confined to the US.
If anything, the developed world is experiencing a synchronised slowdown, and commodity markets are telling us that developing countries will not be immune.
The key change in the past month has been an extraordinary rally in the US dollar, especially against the euro and the Australian dollar – up nearly 10% against both.
Part of this action is purely speculative: US dollar shorts have been caught and positions almost entirely unwound. The market is now significantly net long (that is speculators are now betting, virtually as one, that the greenback will go up).
However the action seems to be primarily a euro sell-off by the “money countries” of Asia and the Middle East rather than a big improvement in US dollar sentiment.
In any case, US economic data is likely to weaken again very significantly in the months ahead, with an official recession confirmed. Another Fed rate cut is likely to cut the US dollar rally short, although the euro itself is unlikely to recover against the yen.
The real story on the first anniversary of the credit crunch is a capital flight from Europe and Australia.
The economic data out of Europe lately have been absolutely terrible and there is very little hope that Germany and Britain, at least, will escape recession. Japan is facing a recession as well.
The European Central Bank’s tough stance on inflation will go into sharp reverse before long, just as Australia’s already has.
Meanwhile the Australian dollar has fallen 10%, partly because of the certainty of a rate cut in September, but mainly because of the broad correction in commodity prices.
Although Chinese buyers have been running down inventories to some extent to squeeze the speculative shorts in some commodity markets, there is clearly a significant element of softening demand in what’s happening.
The reversal is too broad and too uniform to simply be down to action by speculators.
If the sort of economic decoupling that was talked about over the past five years was ever true, it is no more.
In my view we are now seeing the delayed toxic effect of the credit tightening that began last August on business activity around the world.
It is simply the inevitable consequence of removing funding for both working capital and capex, and it always takes a while to sink in.
Global industrial production is falling; shipping and aircraft traffic are both falling; capacity utilisation is down.
And it seems the foreign exchange markets better understand what is going on than equity markets, which have been relatively strong recently.
Moreover credit conditions have not stopped getting tighter, and there is no expectation that the bank write-downs have stopped (we saw another one last night from JPMorgan, which produced a sharp reversal in the Dow Jones).
Indeed it seems to be just a matter of how far past the $US1 trillion mark the bank losses eventually get to (currently at $US480 billion), particularly since there is no evidence yet that the US housing market is approaching a bottom.
What underlies the sudden and dramatic corrections in the euro and Australian dollar is the realisation that decoupling has not worked, and that neither Europe nor Asia will escape the credit crunch.
It was always a vain hope that it would. Banking and debt securities markets are global; why would we think a credit crisis would have borders?
China, and the mind-boggling need for it to build a London every year to house the mass migration from rural areas to the cities, has been, and remains, the key hope for the world’s investors in the face of the collapsing US financial system and the effect of this on global credit availability.
But even that seems to be coming into question as markets get the jitters about post-Olympics China.
A central part of the action on sharemarkets lately has been the sharp reversal of the pattern of falling financials and rising energy/commodity stocks that has characterised most of 2008.
This has badly caught many investors who have relied on the China-good/US-bad story to short banks and go long commodities. That trade is now being unwound, no matter what the fundamentals might be.
At least falling commodity prices are relieving inflationary pressures and should provide central banks with some room to move.
The RBA is already in cutting mode, the Fed will probably cut again, the Bank of England left rates on hold last week in a split decision, but is expected to warn of a recession this week, the ECB must soon move to an easing bias, if not a cut and the Bank of Japan, faced with the highest wholesale inflation in 27 years and falling industrial output is likely to leave rates where they are (0.5%).
The good news? The currency has fallen. It worked in 1997 to insulate the Australian economy from the Asian crisis; maybe it will work again.
This article first appeared on Business Spectator