At a time like this when uncertainty is high then financial markets often cling to trends that were previously present even if the reason for them has weakened. Now you might reasonably argue that even before the conflagration that has particularly impacted on North Africa there was plenty of uncertainty about our economic futures! However the political instability and efforts at regime change have contributed to a sharp step upwards in the oil price. In spite of an increase in Saudi oil production claimed to be 8% we see this morning that the price of a barrel of Brent crude oil is US $113.65. I say claimed because there is a lot of debate over the actual ability of the Saudi’s to do such a thing. Although of course there have been claims that we are about to run out of oil since the early 1970s! The only certainty is that one day they will be proved right. But it is clear that the potential inflationary impact of a sustained oil price increase is coming ever nearer the longer the oil price remains elevated like this.
So what is the previous trend i refer to? It it the strength of the two currencies I labelled as “currency twins” back on the 31st of August last year and they are the Swiss Franc and the Japanese Yen. If you look back in time the similarity in their behaviour does in fact stretch back some ten years or so partly because they were currencies which were heavily borrowed in around the middle of the last decade. However if you look at the values I quoted on the 31st of August then the Yen was at 84.29 versus the US dollar and the Swiss Franc was at 1.292 versus the Euro. This morning the Yen is at 81.8 versus the dollar and the Swiss Franc is at 1.2751 versus the Euro. So what were already very strong currencies as for example, exporters in both countries are having a very difficult time as they are now both uncompetitive in pure price terms, are stronger.
If we consider this situation we may reasonably conclude that in such an uncertain time Switzerland with its reputation for both holding and being involved with gold may be attractive at this time precisely for that reason. A gold price of US $1409 per ounce certainly reinforces her position. But Japan? I pointed out last week that she is the world’s largest oil importer and accordingly it is much harder to single out a reason why her currency is in favour. Indeed there are signs that her economy is coming under pressure as her fiscal deficit and national debt (which is heading towards 250% of economic output as measured by GDP) mount and last month she even had a trade deficit.
What are the implications of this?
For Japan the implications of an overvalued currency for a trading nation can only be poor. Her attempt to intervene against the US dollar at 83 looks even more ill-conceived although she has performed more weakly against the Euro. For Switzerland there are also problems but slightly different ones and from this there are plenty of problems for Eastern Europe. There are always ebbs and flows in any movement but 2010 was a year where the Swiss Franc surged and her central bank the Swiss National Bank intervened on many occasions to try to halt and reverse this. It’s record was one of complete failure and it has declared losses of 21 billion Euros in its latest reported accounts. Even this figure does not fully tell the story as the SNB will have made plenty of money on its gold holdings which are included in the figures. So the gold inspired profits mask some of the currency losses. There is,of course, an irony here as the strength of gold is a major factor in the attraction of the Swiss Franc to currency investors.
So in a nutshell problems for both Japan and Switzerland. But if you look at my article on the 31 st of August 2010 you will see that I wrote also about Eastern Europe and in particular Hungary. The reason for this is that many borrowers in Eastern Europe borrowed in Swiss Francs in the middle of the last decade because their own interest-rates were much higher than Swiss ones and so the monthly payments were cheaper. If you have ever heard the “carry trade” mentioned then this was what it meant in Europe. You may already be wondering at the back of your mind that there is a currency risk here and you may also wonder why Eastern European regulators did not intervene. However there is and they didn’t. Either way here is my estimate from August 2010 of the scale of the problem for Hungary.
To look at the numbers and concentrating on Hungary where this was and is a big factor some 1.7 million mortgages were taken out in Swiss Francs and the total sum borrowed is estimated at around half of her GDP.
Not only is this an issue for Eastern Europe as the strength of the Swiss France leads to an increase in the amount owed it is a problem for the banks which loaned the money as they face the risk of missed payments and even default as the scale of the problem mounts. Lenders to the fore in this operation were often domiciled in Austria and the Nordic nations.
The US Dollar is surprisingly weak
You might at such a time be expecting a strong US dollar as it too often has a safe haven status. Indeed there seem to be some signs of US assets being attractive as US Treasury Bond prices have risen and yields dropped. For example the ten-year yield is now 3.40% after recently surging towards 3.6%. However the trade-weighted US dollar index is at 76.96 which is not only lower than when I looked at it last week but also not that far off its 52 week low which was 75.63 back in April 2010. If a lower US dollar is one of the policy objectives of the US government and central bank then the plan is currently working. As a currency has to fall against another currency which accordingly has to rise the rest of the world may not be quite so enthusiastic!
However the much maligned Euro is putting in a better performance and shrugging off the fact that of the main industrialised countries it is Italy that looks as if it will be adversely affected the most by the unrest in Libya. A year ago it was at 1.36 and today it is above 1.38. It sounds very stable put like that does it not? We all know that the reality was rather different but it is intriguing that the net effect on a year ago is a rise heading towards 2%!
Problems in the periphery of the Euro zone
These do not go away and unfortunately in spite of the way official sources talk of “rescues” in fact problems are mounting. If we look at Ireland I gave my opinion on what her new government should do on Friday. However a relic of the old era has reappeared this morning.
The European Central Banks Marginal Lending Facility has shot up again
Back on the 21st of February I discussed this matter and here is my explanation of what it is.
There are various roles that a central bank performs one of them is to provide liquidity to banks and financial institutions which are in trouble. It usually charges more for this than ordinary liquidity and the term “penal rate” is used. For the ECB the penal rate is 1.75% and it is called the Marginal Lending Facility.
I thought then that Irish banks were at the bottom of the surge in this penal borrowing and they were. However the problem reduced in scale but is now back as according to the European Central Bank this morning it has risen again to 17.115 billion Euros. It may or may not be a coincidence that this coincides with the change of government. However it is not a coincidence that if one looks for further insight to find out exactly what is happening at Anglo-Irish Bank which is responsible for much of this surge one receives a reply which is about as clear as the mud in the woods of Surrey right now (memo to Shaun downhill short cuts in sodden ground may not be wise). Obfuscation has been a problem as the Irish banking crisis has developed and more of it only confirms me in the view I expressed on Friday that there are more hurdles ahead for the Irish banking system. Her new government has plenty of difficult tasks ahead.
There were several questions in the comments section at the weekend asking if there was a “key” number which would mean that Portugal had to ask for help. I offered the view that in my opinion the date at which she should have done so was months ago as recorded on here but that there is in fact no key number. For the purposes of completeness another number has emerged in the media as the Financial Times has pointed out the following fact.
Portugal’s benchmark market interest rates were above 7 per cent for the 16th consecutive trading day on Friday, closing at 7.55 per cent. Greece and Ireland, the two euro zone countries to seek bail-outs so far, lasted 13 and 15 trading days respectively with bond yields of more than 7 per cent.
With talk of the Monkees reforming then it may well be ok to say “I’m a believer” but I remain of the view that there is no magic formula only increasing risk of long-term insolvency. Also the FT is a little vague about what benchmark it means when it is in fact ten-year government bond yields.
I can see no realistic gain in Portugal letting herself be exposed to financial markets whims like this. I can however see why she does not wish to follow the path of Ireland and Greece where so-called “rescues” are at best hitting difficulty and in my view are entirely misconstrued. My suggestion is that she should call in the International Monetary Fund on its own. She can do so because she has a genuine balance of payments problem. Not only would it be refreshing to see the IMF respond under its original and to my mind proper mandate the lower cost of the funding at between 3 and 3.25% would be much more affordable for Portugal than the 6% plus which is the likely charge from the various vehicles of the European Union and the Euro zone.