CreditSights: The Week In Credit
Although markets stabilized late in the week they have not yet shaken off the bout of jitters caused by the communiqué embracing flexible exchange rates issued by the G7 finance ministers as they wrapped up their last series of meetings. We are somewhat mystified why the market seemed to take quite so seriously the idea that a purely political statement issued jointly after a weekend love-in would actually be the means by which to communicate what would amount to a reversal of long entrenched currency policy by some of the signatories. Investors certainly seemed to give it more credence than did some of those who signed it but were busy clarifying its lack of relevance before the ink was dry.
Maybe it's just the time of year. Heading into October one is loathe to make too much of the seasonal preponderance of disaster and mayhem, which consistently delivers more tricks than treats, for fear of giving rise to a self-fulfilling prophecy. Trading sessions such as last Monday's however, suggest that the thought is uppermost in many minds and conviction as to the current level of prices in several asset classes is ebbing. From this perspective, the heightened sensitivity to any changes in currency policy is more understandable. There are several grand imbalances in the current global economy and foremost amongst these is the valuation of the U.S. dollar relative to its Asian trading partners and the degree to which the U.S. is sucking up the world's capital.
To this end, a competitive devaluation of the dollar, particularly against Japan, China, and the rest of Asia, would help promote U.S. exports, curb imports, foster production, promote domestic job growth and reduce the foreign borrowing requirement. Gaining all this for running the risk of sparking some mild inflationary pressure appears an attractive trade off by any measure. Little wonder Treasury Secretary Snow is pounding the table about exchange rate flexibility but a shift in global currency regimes is unlikely given the benefits a strong dollar affords to our trading partners.
Nor is it certain that a dollar devaluation wouldn't come at a higher price to the U.S. than just a rise in the inflation rate. The U.S. debt dependence is largely funded by the beneficence of foreigners, with a strong bias to the very region we would like to see allow the dollar to be taken down a peg or two (or off the peg as the case may be). According to Treasury Department data, the Asian region accounts for 53% of the current ownership of U.S. Treasury debt. Japan alone accounts for 32%, holding in excess of $440 billion of Treasuries. And the trouble with currency devaluations, particularly ones that take place after one has embraced freely floating exchange rates, is that they do not happen gently. The intention may be to move the dollar, but the risk is that a huge swathe of foreign investment moves along with it.
These were perhaps the salient points that are unnerving markets. An issuer with an ever-growing borrowing requirement has a certain vulnerability to such a concentration in its investor base. The good news is that historically the Japanese demand for Treasuries has proven to be much more stable than the dollar yen exchange rate. In fact over the past decade, a period that captures several instances of sharp currency realignments, there does not seem to be a strong relationship between the dollar and the level of Japanese demand for U.S. Treasuries. That doesn't remove the imbalance inherent in the current global allocation of capital, but it should ease the threat of a massive repatriation of Treasuries from Asia as a result of currency gyrations.
For corporates, this may all seem to be a bit of an esoteric debate, but as index option adjusted spread levels continue to grind tighter and the chorus of advice persists with its benign view, the compensation for assuming spread risk continues to erode. Corporates are basking in continued low volatility levels but the transmission mechanisms remain in place for an external market stumble to feed directly back into spread widening pressure. However, we do get the sense that the market is currently much less exposed to the fast money or leveraged play than it was last year and hence will likely maintain greater resilience to flights of nervousness in other markets. Resilience, but not indifference.
Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.