Risk aversion comes screaming back
–Jane Foley is research director at Forex.com. The opinions expressed are her own.-
The Greek fiscal crisis has forced investors to weigh up the risks of sovereign default very carefully.
Funds have moved out of peripheral European bond markets and into U.S. treasuries, JGBs and even (prior to the election result) the UK gilts market. The crisis has also forced investors to reign in their overall appetite for risk.
This is clearly evident across asset classes. Even before the dive in U.S. stock markets on Thursday, the majority of European stock market indices and a large portion of Asian had already given up their gains for the year and oil prices had moved well below their recent highs.
In the FX market safe haven demand tends to boost both the dollar and the Japanese yen. Currently the dollar’s gains are, unsurprisingly, most marked vs the Euro. The massive demand for the Japanese yen on the back of the rout on U.S. stocks is reminiscent of previous crisis.
Unless the mood improves noticeably in the next few weeks, risk aversion amongst investors could be sufficient to undermine the pace of the global economic recovery. Some of the impact of last year’s simulative government and central bank policies could in effect be negated.
U.S. fundamentals are far from perfect. The recent correction lower in the U.S. savings rate suggests that the U.S. will continue to carry a huge current account deficit in the foreseeable future. The budget deficit, which could be above 11 percent of GDP this year, is also potentially a huge problem.
Fiscal repair is unlikely to take a strong hold in the US until next year, but when it does this could be a significant restraint on growth potential.
That said, the crisis in the Eurozone reflects kindly on the U.S. The U.S. has its share of fiscal issues but the fact that the U.S. operates as a federal system and not as a cluster of sovereigns with no real fiscal controls means that policy responses are far clearer cut.
The EMU is yet to prove whether it is possible to run a monetary union without close fiscal ties. The current crisis in Greece could yet end with a Greece default.
It could also undermine the integrity and even the sustainability of EMU. The U.S., unlike some countries within the EMU periphery, has no meaningful history of default.
For the time being, the crisis in the Eurozone is likely to put an end to all speculation that global central banks will diversify away from dollars in favour of the Euro.
Given that Japan’s huge debt, aging population and declining savings ratio implies a huge fiscal problem for the next generation, the yen is no real contender for reserve currency.
In balance, U.S. treasury debt is likely to remain favoured markets assets and this suggests that a period of broad-based dollar strength could be approaching.