Last week, I laid out a case for a weakness in growth prospects for the US economy, given the likelihood of trouble in its housing sector. It was not just a case of excess supply as more houses come into the market but also one of rising financial distress. Of course, financial markets are like our makers. They choose to mock at our seeming intellectual arrogance and contentment. Two sets of data in the US—the housing starts (laying the first brick or ‘breaking ground’) and the sale of existing homes— turned out far better than expected. Financial assets globally have breathed a sigh of relief. Indian readers would not have missed it either in their stock markets.
As has been their wont in the last two/three years, investors have developed a remarkable tendency to look at the sunny side of things. The confidence of US home builders declined rather sharply in March. Most experienced investors would view that as a forward-looking indicator of how the housing market would develop, rather than feeling relieved at the sale of homes (new or old) in the previous month. In addition, US leading indicators fell sharply in February and the small positive number in January gave way to a negative change. Therefore, we have had two consecutive months of sizeable declines in the leading indicators. As this indicator has a good track record of presaging recessions in the US, one must attach a high probability of a recession in the US in the coming two/three quarters. But investors ignored this data as it didn’t fit into their sunny framework.
Similar was their disposition towards the communication released by the US Federal Reserve. The committee in the American central bank (equivalent of India’s RBI) that decides on official interest rates made no change to the key, short-term rate for overnight loans to banks, at 5.25%. That was no surprise. They made some important changes to their press statement. Hitherto, they had felt that the next move in rates was more likely to be up than down, and that the only undecided elements were the timing and the magnitude of such an increase. They dropped that line. At the same time, they insisted that they were concerned about inflation remaining above their “comfort” levels (2.7% vs 2%). Importantly, they changed their assessment on US housing from “stabilising” to “ongoing adjustment”.
While certainly this means that they are open-minded on the next move in interest rates, they were also hinting at the potential combination of high inflation and slowing growth. Economists’ contribution to the English dictionary is to come up with a term called “stagflation” to describe such a combination. Perhaps, it was too abstract to register in investors’ minds. Consequently, share prices jumped on the Fed taking their finger off the interest rate button. The US dollar weakened, as it should.
What the leading indicators suggest is that the economy could slow down significantly. The Federal Reserve has expressed a dilemma. But, the American central bank, being a politically-sensitive institution, would be forced to drop interest rates regardless of whether inflation was above or below their comfort zone. Past form indicates that too. If the past is no guidance to the future and Ben Bernanke (the chairman of the Federal Reserve) is less inclined to ride to the rescue of avaricious mortgage lenders, ignorant borrowers and their willing collaborators on Wall Street as his predecessor used to do, then the risk is that the growth gloom is stark. Therefore, whichever way we slice the argument, the US dollar has to fall quite a bit against other currencies.
America is usually sanguine about US dollar declines. After all, it is a large economy and imported inflation because of a cheap currency is a remote threat. Further, all its debt is denominated in US dollars and hence a falling dollar is a legitimate way of defaulting on the debt while the burden falls entirely on lenders. These are additional reasons to bet on a dollar weakness in the months ahead.
Exchange rates are about relative fundamentals and not just about the darkening clouds on America’s economic horizon. Much could be written about equally bleak and more long-term economic prospects in the Eurozone. The proportion of economically active population (15-59 years) in 2050 would be less than 50% in Italy and in Germany, whereas it would be 56% in the US. That is vital for innovation, creativity, entrepreneurship and productivity.
Therefore, what do investors do when all currencies face short-term and/or long-term challenges? Well, in these times, it is not going to hurt at all to load up on gold and silver and there is the bonus of a happy home that comes along with it.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd.