Where does the buck stop?

These are dramatic days in the markets, above all in the foreign exchange market. Israelis may be forgiven for thinking that there is some major domestic economic development taking place, that is pushing up the value of the shekel against the dollar – because that’s how the local foreign currency market is being presented in the media. In fact, however – and despite specifically local factors such as interest rates on the shekel being nudge slowly higher – what is happening locally is part of a much broader picture. The dollar has been falling all around the world, and with increasing velocity.

Yesterday (Thursday) was an exceptionally dramatic day, even by recent standards. Again, the local market provided at least its fair share of drama, as the shekel’s upward march against the dollar resumed and took its price below 3.60 to the dollar (remember, a lower price = a higher value; if there are three shekels to the dollar, its value is higher than if there are four). The Bank of Israel then began intervening and a huge battle took place between the Israeli central bank, which is the only major player still willing to buy dollars, and a slew of foreign and domestic financial institutions (that include banks, their hedge fund customers and other speculative traders), which were pouring dollars into the market and buying shekels by the truckload. The Bank of Israel ended up buying an estimated $700 million, by far the most ever in a single day’s trading — but even this did not prevent the shekel bouncing back, so that the representative rate fixed in mid-afternoon was at a lower price than on Wednesday and hence another 2-year low.

Why is the dollar plummeting? The main cause is the universal expectation that the American central bank will announce, on November 3, that it is undertaking another massive program of buying US government bonds, to the tune of a trillion dollars, possibly more. This renewed flood of dollars is aimed at jolting the sluggish American economy back to life. Many economists are highly dubious that it will succeed in this aim, but everyone is certain that the program will cause bond prices to rise and will also cause the dollar’s value to fall (in simple terms, there will be more dollars for the same amount of everything else, so the price of everything else in dollar terms will rise).

The markets, typically, have not waited to see if and when this expectation will be realized, but have acted according to the adage “buy the rumor, sell the fact”. Pretty much all financial assets have risen quite sharply in price since Fed Chairman Ben Bernanke signaled his intentions in late August. But the fall in the dollar and rise in other currencies is not a desirable outcome for most countries, because it makes their products more expensive in the US and in other countries whose currencies are effectively tied to the dollar – primarily China.

The result has been a growing number of countries openly intervening in the currency markets to stop their currencies rising, by buying dollars. Israel has been doing this since March 2008, when Stanley Fischer abandoned the Bank of Israel’s policy of non-intervention in order to prevent Israeli exports becoming priced out of global markets. The Chinese and others have also been manipulating their currencies for years, but they do not have floating exchange rates, so their activities are not transparent. Now, however, the Japanese, the South Koreans, the Brazilians and many others are all engaged in selling their own currencies and buying dollars – or imposing some restrictions on the free flow of capital into their countries, even though this is considered an even greater crime against the dogmas of neo-liberal economics than intervention in the supposedly free market.

But the writing is on the wall for free capital flows, and maybe even for freely floating currency regimes. The International Monetary Fund is the Vatican of the neo-liberal economics church and its managing-director is the Pope. So when IMF m-d Dominique Strauss-Kahn said yesterday that there was no chance of a reprise of the co-ordinated international approach to currency crises exemplified by the Plaza and Louvre Accords of 1985 and 1987, he was implicitly admitting that the idea of a Plaza sequel was on the table. Strauss-Kahn was also reported by Bloomberg to have said that the term “currency war” – used last week by the Brazilian finance minister to describe the state of the global currency market — is “maybe too military,” though “it’s true to say that many do consider their currency as a weapon and that’s certainly not for the good of the global economy.”

In short, the pressure on countries to respond to the markets is becoming intense. The markets themselves are hugely skewed, with some 96% of traders expecting the dollar to fall and the euro to rise. The percentages expecting a continued rise in precious metals are almost as high. If sentiment index existed for traders views of the shekel it would probably show a similar bullish extreme. These are classic conditions for a reversal and it would not be surprising to see one occur very soon. But if the annual meetings of the IMF/ World Bank being held over the next few days in Washington produce some kind of political deal regarding the currency markets, the reversal in the markets could be even more dramatic, swift and powerful than the move that preceded it.

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