Pound Sterling as a Safe Haven?

Good day. And welcome to another week. Chuck is headed out to Las Vegas today, to speak at the MoneyShow. With the travel and difference in time zones, he thought it would be best if we picked up the Pfennig for him this week, so I’ll be sharing my thoughts on the currency markets with you this week (hopefully, with a little help from Mike Meyers).

The euro (EUR) hasn’t gotten any help from the Greeks lately, and the currency markets continued to move out of “risk” positions and back into safe havens on Friday.

I spent a good bit of time this weekend reading up on the Greek political situation, and stole the “Achilles’ heel” phrase from this week’s Economist magazine. I thought that description was perfect for the Greek vote, as the euro has stumbled because of the recent uncertainty in Greece.

Greek leaders have been unable to form a unified government, and there is a real possibility that the Greeks will be heading back to the polls for another vote. As Chuck reported last week, European leaders have approved the next round of bailout funds for Greece, but with the continued leadership vacuum, I have to think this could be the final payment.

If they have another election, the markets will certainly see it as a referendum on whether the Greeks want to stay in the euro. A vote for the same anti-austerity parties would certainly put pressure on European leaders to rethink Greece’s membership in the single currency.

We have heard warnings over the “end of the euro” almost since it began trading, and I never put much credence in those who felt the euro wouldn’t last. But I do think the euro will evolve with the markets, and a Greek departure is a real possibility.

I think the euro will actually be stronger without Greece, like the buffalo herd that is being chased by a pack of wolves. The exit of one, or even two, of the weakest members will actually make the remaining group stronger. But the exit could get ugly in the short term, which is exactly what Chuck warned all of us about in his “currency projections” for 2012.

The euro also weakened after a report released this morning showed industrial production in the euro region contracted in March. German manufacturing was the one bright spot, but gains in Germany couldn’t overcome slower production in Spain and France. Industrial production slipped 0.3% from February, versus forecasts of a 0.4% gain. From a year earlier, production declined 2.2%.

The Greek political uncertainty weighed on the euro Friday, and today’s poor production report continued to push the euro lower, sending it near the lows for the year. The uncertainty in Europe has investors moving out of anything that can be associated with “risk,” which means the higher-yielding currencies got sold.

Looking at the currency screens this morning, the only currencies that are appreciating versus the U.S. dollar over the past month are the British pound (GBP) and the Japanese yen (JPY). I expected to see the yen at the top of the list, as the Japanese currency is seen as a “traditional safe haven.” But the pound sterling was a bit of a surprise.

The pound is being sought out by investors who are looking for shelter from the turmoil on the European mainland. The sterling has appreciated 3.6% this year, a surprise move considering the poor economic fundamentals in the U.K. The Bank of England has been flooding the financial markets with sterling in an attempt to boost the economy, so the appreciation in the face of all of this liquidity is even more impressive. But is the recent appreciation in the pound sterling justified? I hardly think so. The U.K. economy fell into its second recession in the first quarter, the first double dip since 1975. U.K. output is almost 4% lower than the peak in 2008, and unemployment is close to a 16-year high, at 8.3%.

Perhaps currency investors are just looking for political stability, which the U.K. can provide in contrast with the European turmoil and the U.S. elections. Prime Minister David Cameron is sticking to the austerity programs he instituted after his election two years ago, stating that deficit reduction is needed to keep interest rates low. The S&P rating service has affirmed Britain’s AAA rating and stable outlook, a confirmation of Cameron’s calls for further fiscal tightening.

The more traditional safe haven of the Swiss franc (CHF) hasn’t seen a big rise, as the Swiss National Bank has kept its promise to keep its value tied to the falling euro. So currency traders have turned to the pound sterling for shelter from the European economic storm. As Chuck pointed out last week, the U.K. is winning in the “ugly contest” in Europe, but I would certainly think there are some prettier places to park cash (the Nordic currencies are a prime example).

The Australian dollar (AUD) dropped below parity for the first time this year, a pretty dramatic move from a high of $1.0856 at the end of February. The “breaking of the buck” is a pretty big psychological move, and will probably send the Aussie dollar even lower. The commodity currencies all got sold as investors exited “risk trades.” The carry trade continues to be a popular investment strategy, but volatility in the markets can cause losses for these trades, so the renewed European crisis caused investors to sell the high-yielding currencies and move back into the relative shelter of the U.S. dollar and Japanese yen.

The Australian dollar continued to slide in spite of a report that showed the nation’s housing market is improving. Home approvals unexpectedly rose in March, the first positive move in three months. The number of loans granted to build or buy houses increased 0.3% in March versus the Bloomberg median estimate of a 2% decline.

The Aussie dollar, New Zealand dollar (NZD), and South African rand (ZAR) are all dependent on demand for commodities, and most of that demand now comes from China. Demand for the commodity currencies was boosted a bit after China lowered reserve requirements for banks in an effort to stimulate their economy. The PBOC also turned their currency around again, letting it slip vs. the U.S. dollar. China has held off lowering interest rates, choosing instead to reduce reserve requirements and lower the value of their currency. The 50-basis point move, effective May 18, will inject about 400 billion renminbi of liquidity into the banking system, according to estimates by ANZ.

The two moves by China indicate the Chinese policymakers are concerned about the recent slowdown in the global economy. Chinese leaders are looking to boost their economy after a batch of disappointing economic data was released last week. Two separate reports showed China’s industrial production and retail sales grew less than forecast. The industrial output in China increased 9.3% in April, the least since May of 2009. Estimates of Chinese growth have been steadily lowered, down from lofty double digits to the current estimate for 7.5% growth in the second quarter. China’s growth rate slowed to 8.1% in the first quarter from close to 12% just two years ago.

The Chinese economy continues to be the engine of global growth, so any further adjustments to growth projections can have dramatic effects on the currency markets. Many in the markets are wanting to see the Chinese become even more aggressive in their attempts to stimulate growth, and if growth slips below 7.5%, I think we will definitely see more aggressive moves. The 7.5% level has been widely discussed as being the level of growth necessary to maintain harmony in the Chinese economy. A lower level of growth risks social upheaval by Chinese workers who have come to depend on these higher rates of growth.

And a report out of India showed inflation in the world’s second-most-populous nation accelerated in April. The benchmark wholesale price index rose 7.23% from a year earlier, after climbing 6.89% in March. Higher inflation will definitely limit the room for further rate cuts by the Reserve bank. The RBI slashed the benchmark interest rate 50 basis points last month, and further rate cuts were expected in June. But the recent rise in inflation has cut these expectations and should actually help put a floor under the Indian rupee.

To recap: Greek political uncertainty continues to push the euro lower, with a Greek exit from the euro a definite possibility. The pound sterling is being sought out as a “safe haven” currency, taking the place of the Swiss franc, which is tied to the euro. The Australian dollar fell below parity for the first time this year as risk trades got reversed. The Chinese renminbi turned around and headed lower again after the PBOC lowered the reference rate. And a report out of India showed inflation unexpectedly accelerated in April.

Chris Gaffney
for The Daily Reckoning