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Trade Desk Thoughts
Usd and Gbp Against Eur and Aud
Economic deficit is back into play
Risk-aversion has dominated the traded market focus during the credit crisis, as the global economic business cycle swung from peak to contraction and then fell deeply into the trough, all the time ignoring anything else that did not reflect fair value on the new acceptance of limited risk.
The reasons come sharply into focus on the anniversary of the Lehman Bros collapse, in what now looks to have been the pinnacle of chaos that started the liquidity crisis in September 08. Those sitting at trade desks literally saw the markets implode, as fear of loss overrode all else, as the financial rulebook was re-written, by those that had allowed the chaos to reign.
Pre-credit crisis moves had investors moving away from the dollar due to the ever-increasing U.S. budget and trade deficits, referred to affectionately as the twin deficits. A twin deficit implies that a country imports more than it exports and uses foreign money to cover the excessive demand. In the end, this cannot be supported by the real economy without devaluing the local currency, since twin deficit also implies excessive printing of money.
In most cases, the trade deficit arises because the internal demand cannot be satisfied by the local offer of goods and services. As such, households turn to foreign made goods, which drive imports higher. When a household or a company buys foreign made goods, it actually increases the money supply by the good’s price, until the debt is paid back. The increase in the money supply has negative effects on the local currency, since it devalues it compared to the other currencies (more is less in this case).
On the other hand, when the government runs a budget deficit, it means it spends more money that it currently has. This usually happens when the government tries to stimulate the internal demand by shifting the aggregate demand slope upwards, which corresponds to higher real GDP, but also corresponds to higher prices, thus inflation.
Inflation is known to erode the value, in real terms, of a printed note, as it creates a loss in the currency value as economic imbalances are addressed. In order for a government to fund this extra spending, it has to borrow money from household, corporations and foreigners. Right now, 25% of U.S. debt is held by foreigners, which is bad news for the dollar, since this adds strong downside pressure.
The U.S. twin deficit was ignored during the credit crisis, but in the pre-credit crisis period, the currency market was pricing in the dollar’ decline, with the euro heading towards the 1.60 area. Now, that the global economy is showing strong signs of stabilization, the currency market may start once more to price in the currency fundamentals, and get back to interest rate/forward growth/forward debt ratios.
From where the global economy is standing right now, the aussie and the euro seem to be the best placed, while at the other end of the scales the pound and the dollar can be found, as two economies that seems to be walking in lock-step with each other.