ARTICLE (March 06 2009): A lot of people are surprised to see the US dollars strength, especially when there is a financial crisis in USA and the US economy is in doldrums. Losses of banks, insurance companies and corporates have reached over a trillion dollar mark. Overall, it has a long list of financial problems. Though the crisis is not only restricted to USA, the disease has engulfed the whole world.
Asia is comparatively better placed because of over 5 percent growth in China and India. But the global recessionary impact is certainly spilling all over the region. Despite moderate growth in Asia the weakening factor for the Asian currencies is that the trade volumes of Asian economies are largely dollar-based and the emerging economies are finding it hard to get easy access to USD due to liquidity squeeze since the currencies of emerging markets are not convertible and most of their trade is US dollar based. Here is one good reason for dollar demand.
Japans economy, that has faced recession for several years, is still wobbling and struggling to come out of recession. It did come out of recession for a brief period, but again fell a prey to the global slow down. Japan has a yen 10 trillion ($108 billion) stimulus plan to lift its domestic market, which is already pending for parliamentary approval to support households and the unemployed. Its economy, that is largely dependent on exports for overall growth, is facing the pain.
The current global slowdown is unlikely to help Japan to recover from recession. Japan has its own typical problems and hence, it should rely on fiscal stimulus and avoid sufficient monetary stimulus to depreciate the yen/dollar exchange rate. The recent strengthening of yen against the US dollar, euro and other currencies has considerably weakened Japans international price competitiveness. Its auto industry is in doldrums and its electronic industry may not yield good profit.
It requires expansionary domestic policy. Instead, there is a high probability that it could experience deflation. Hence the current weakness of yen could stretch beyond 103.80 before recovering. Furthermore, it is evident that the currencies of the emerging markets economies are in severe pressure due to dollar demand. Hence, we have witnessed FED and European Central Bank offering dollar swap facility against their domestic currencies to ease off the pressure. This is why we are witnessing strong demand for US dollar.
Back in July 2008 euro was trading around 1.60 against the dollar due to positive economic growth and favourable interest rate differential. Today, European interest rates are close to flat and I suspect further cut in interest rates due to severe recession and negative growth. Euro zone economy has two big problems. European economy, namely Spain, Greece, Portugal, Ireland, Austria and Iceland are suffering due to high rate of unemployment and rising deficit.
While the East European economies are at the verge of collapse due to housing mortgage loans taken against borrowed overseas funds and now since the Eastern European currencies lost their value sharply, they are in a fix in converting their domestic currencies against euro, which is again bad for the European economies and there is high risk of East European economies for default. The probability of default is high after refusal by European leaders to the demand of injecting USD 380 billion to rescue East European economies.
This is again bad news for European currencies. But we have to keep in mind that USA has bigger losses requiring more money for capital injection. Therefore, in my view, there is bigger risk of currency volatility. Technically, strong support for Euro lies at 1.1820. Only a break here would see a fall towards 1.10, a less likely scenario. While, on the upside euro needs to break 1.4020 for a push towards 1.5050.
We suspect that UK economy will not take too long to recover from recession, as it is caught in the bottom. Hence, pound sterling will find strong support around 1.35 before bouncing back. We do not favour investments in Swiss franc as Switzerland is going through a crisis against its secrecy law. There is a huge risk of financial chaos all over the globe and cash is king as lenders are refraining from investing their funds into risky businesses forcing Central Banks to adopt a policy of quantitative easing.
Central Banks flood cash against government debt, mortgages, commercial papers and stocks. Quantitative easing is a tool used by Japan about a decade ago to avoid deflation, which certainly signals a desperate situation. It is most likely to backfire, as it also risks high inflation, as printing of notes does not serve the purpose without a collateral. Furthermore, US stimulus plan will also lead to inflation. China is the largest foreign holder of US Bonds, with $696 billion, followed by Japan, with $578 billion.
With so much risk involved, investors preference is for buying gold. There is a huge demand for coins and gold bars, which has a delivery time of 4 weeks and 8 weeks. Gold has a strong support at $850, a preferred buying area with a major support line at $780. A break of $1200 would confirm next target of $1380. In Pakistan, 10-gram gold, which is trading at Rs 22,000 and is likely to surge towards Rs 30,000 by the end of the current calendar year.