Beware the Ides of August

The historic significance of August 15 tends to be under appreciated. It is the day in 1620 that the Mayflower set sail from Southampton with 102 Pilgrims aboard that were destined to change the world. As they celebrated their anniversary 15 years late, the Plymouth colony was hit by its first hurricane. In 1914 the Panama Canal opened, which was both the cause and effect of the previous attempt at globalization. On August 15, 1947, India won its independence form Great Britain. In 1994, arguably the most famous terrorist before 9/1l Carlos the Jackal was arrested in Sudan.

This August 15 marks the 35th anniversary of the end of the Bretton Woods system of fixed exchange rates. Unwilling to continued to allow foreign central banks (especially the Bank of France and Great Britain) to convert their dollars to gold, US President Richard Nixon closed the gold window, without negotiations, and ushered in the current era of floating exchange rates.

Like the US, nearly every country that has allowed their currency float did so in a crisis. Driven by market forces, many countries had little choice. Others chose to de-peg their currencies as the least poor policy option. That most countries were reluctant to let their currencies float has been evident from the very start. Europe for example devised several schemes to limit their currencies from fluctuating against each other, culminating in the adoption a single currency in 1999. As is well appreciated Japan and most countries in Asia are uncomfortable allowing the market to fully determine the price of their currencies. In this regard China stance is hardly exceptional.

Ironically, back at the end of WWII as US Treasury’s Dexter White was working with the UK’s John Maynard Keynes at Bretton Woods to design the architecture of the international order, there was no question. Exchange rates were to be fixed and cross board capital flows limited. This was economic orthodoxy. That was then this is now; and of all that the US produces, perhaps it excels in nothing as much as making a virtue out of a necessity.

US officials insist that other countries take the same medicine as a general cure for all ailments. But it is not lost on many foreign officials that the fixed exchange rates after WWII coincided with among the strongest growth periods of the 20th century. The rapid development in East Asia, including Japan and China, is difficult to envisage if it were not for limited currency movement. Some officials in developing countries accuse the US in particular, but the West in general of kicking the developmental ladder down after it climbed up.

Consider too Malaysia’s experience since the 1997-1998 Asian financial crisis. While most of the afflicted countries turned hat in hand to the IMF and in exchange for the assistance, Malaysia battened down the hatches, imposed various capital controls and maintained a pegged currency. Their economic performance between then and last July, when like China, began to allow some, albeit modest, currency movement, was no worse and arguably somewhat better than many of the other countries in the region.

This anniversary of the fiat (that is not backed by precious metals) regime offers investors and observers a golden opportunity to reflect on the merits and demerits of floating which means volatile currencies.

In addition to commemorating that anniversary, August 15th also has the potential to have more immediate impact on the global capital markets and especially the currency markets. First, the US Treasury will make is semi-annual coupon payment. This amounts to something close to $21 bln. A little more than half of US Treasury’s marketable securities are in foreign hands.

The market tends to focus on the Japanese holdings, which as of end of May, were about 15% of outstanding Treasuries. This means that Japanese investors (public and private) will receive around $3 bln. The market expects some of these proceeds to be sold (for yen as in repatriation) or hedged.

The regularity of the US coupon payment is likely part of the seasonal pattern that has been widely noted in which the yen tends to appreciate in the month of August. This also bears out another important point to consider: namely that the income that Japanese investors earn from their foreign investments is a more important (and stable) contributor to Japan’s current account surplus than Japanese exports. Again because of the US Treasury’s coupon payment, Japan’s investment income account typically shows the biggest surplus in August.

Another source of the regularity may be the Obon holidays (a Buddhist holiday honoring ancestors) which this year peaks next week and could make for thinner participation in Japan. Japanese exporters, generally dollar sellers, often put standing orders in the market, while importers, often dollar buyers, tend to transact more directly. In holiday thinned markets, this tends to lend a firmer tone to the Japanese yen.

On this August 15th, the US government will also report a several important pieces of data. The July producer prices are expected to rise 0.3% after rising 0.5% in June. The core and headline year-over-year rates are expected to ease slightly, which may boost some investors’ confidence that the Fed’s pause will likely extend in September. The consensus expects the headline rate to moderate from 4.9% to 4.5% and the core rate to 1.7% from 1.9%.

The market will also receive the August Empire State Manufacturing Survey. It is expected to ease for the second consecutive month. It most recently peaking in March near 29.03 and retested it in June (29.01) before falling to 15.64 in July and is expected to slip to 15.3 in August. It is may not carry the gravitas of some other regional surveys, though many economists will use it to fine tune forecasts for the national ISM manufacturing report out a couple of weeks later.

The report that day that will likely cause more ink to be spilled and potentially more market impact is the Treasury’s monthly international portfolio investment report (TIC). The Aug 15 report will cover the month of June. While forecasting high frequency economic data is fraught with risks and uncertainty, the TIC data is exceptionally difficult to predict. There are few inputs. Consensus numbers need to be taken with an even larger grain of salt than more forecasts.

That said, in May, the US imported a net $59.6 bln of portfolio capital. The consensus expects a decline to about $63.2 bln, which would be just below the June trade deficit of $64.8 bln. Since there are other channels in which the US finances its trade flows and more broadly its current account deficit, comparing the TIC data to the trade deficit is probably not the best metric.

Another way to think about the monthly TIC data is to put it in the context of the quarter’s performance. If the consensus is right, the net portfolio inflows in Q2 will be around $184 bln. In Q1 06 the figure was closer to $225 bln, but in Q2 05, foreign investors bought a net of almost $152 bln.

The risk to the consensus forecast appears to be on the upside. Recall that in June emerging markets were melting down and global equities in general had a difficult time. Although foreigners might not have been large buyers of US shares, the unwinding of emerging market positions and the demand for safety and security, may have encouraged inflows into the short-end of the US debt market. For their part, US investors liquidated billions of dollars worth of emerging market stocks and this may be picked up by the net figures.

Yet when the dust settles and August 15th passes, the US dollar is likely to remain within its well-worn ranges. The big range for the euro is roughly $1.2450 to $1.2950. That is the range that has, with few exceptions defined the price action over the past four months. There is little reason to expect a near-term break of this broad range. Market sentiment is dollar bearish, but the weight of currency positioning appears to be reinforcing the upper end of the range.

The dollar’s range against the yen is less clear cut. For the better part of three months, the dollar has been confined to a JPY113.50-JPY118.00 trading range. What the market understood as weaker than expected Q2 GDP (which we suspect was really stronger than the optics) provided the incentive to take the dollar to JPY116.40 a key technical retracement target. A convincing break of this area would target JPY117, but also spur talk of JPY118. Initial support is seen near JPY115.50 and then JPY115.00.

One consideration that might mitigate the favorable seasonal pressure on the yen is that the market participants seem to continue to prefer carry-trades (selling low yielding currencies like the yen, the Swiss franc and/or the Norwegian krone) and buying higher yielding assets) rather than other investment themes, like safe havens plays (which typically low yielding current account surplus countries.

In any case, beware of the ides of August. To be forewarned is to be forearmed.