Currencies at War

How did it start?

2014 and 2015 have seen huge swings in currency markets and many wonder why the sudden increase in volatility? You probably know the factors that are driving currency markets potty:  The GFC of 2008 was to be cured by quantitative easing (QE), massive injections of liquidity to support world economies. They survived but currencies are in turmoil.  

Please note: all charts are made with Chartnexus data and software.

USD devalues 30% during QE1 & QE2

During the QE program of the US, the USD purchasing power declined roughly 30% against major world currencies. Thus, the US export industry enjoyed a considerable price advantage, which contributed to the overall economic recovery and the US stock markets. 

USD during QE3 etc. to end of QE

During the QE measures that followed, the USD stayed low. Only once the FED started TAPERING, i.e reduce the amount of bond purchases in February 2013 and eventually stop purchases altogether in October 2014, did the USD come to life again. 

The USD rally received a further boost by the decision of Japan's and Europe's central banks to start their own stimulus program, resulting in a huge outflow of moneys from EUR and YEN, as investors switched to USD and other US assets.

Turning Currency Markets Upside Down

Suddenly, Japanese and European products had become a lot more competitive. Emerging markets, relying on demand for their products from US, Europe, Japan etc., vigorously defended their currencies against imported inflation from high priced US while remaining competitive overall. It soon turned into an aggressive, fast moving battle, and soon enough it was termed a "currency war".  

This war is about “Who wins the race for the most competitive currency and with it, the greatest trade &  price advantage!” 

Arguably the main adversaries are the USD and the Euro, if only as a result of the interest rate differential, created when the FED stopped its QE program and the Euro Zone embarked on a huge new QE program, called TLTRO, or Targeted Long Term Refinancing Operations. Just as quickly as it was introduced the Euro fell to a new multi-year low against many currencies. Other countries were forced to revisit previous decisions of how to align with which currency.

The Swiss Example

 Earlier in 2011, the Swiss had decided to fix the exchange rate of the CHF with the EUR, while the EUR had been appreciating strongly, and the Swiss Franc (CHF) had not. The Swiss National Bank (SNB) cited "damaging instability" as the major reason. 

In recent years, the EUR had been falling hard (from $1.48 to $1.10) and dragging the CHF down with it. Thus, on Jan 15, 2015, the SNB decided to untie its currency from the EUR, citing the same "damaging instability" as reason for its action. As a result, the CHF was suddenly trading 20% higher than the EUR. 

What do you do when you wake up in Zurich to find your groceries, etc. are suddenly 20% dearer? You go shopping across the border in Germany, Austria, Italy, or France! Even the holidays cost so much less now. As for its neighbours, many decided to go skiing in French or Austrian Alps this winter. Swiss holidays had become too expensive. 

Even now, a half year later, the shopping trips into neighboring EU Zone countries continue, which somehow must have had a notable impact on the retail business in Switzerland. How will prices adjust? Do Swiss prices go down, or will the neighbours increase theirs - due to extra demand?

SIX around January 2015, CHF appreciates...

Another notable impact of this Central Bank intervention can be seen in the Swiss Stock Exchange (SIX). On the day, 15-1-2015, the index fell 16% intraday, almost negating the appreciation of the CHF.  This is an interesting factor people often overlook: REAL VALUES, like stocks and shares - or groceries, adjust to a change in nominal (currency) values, sometimes immediately like here in the SIX, sometimes it takes a while. Just because the "measure tape" (the CHF) is using larger units, like inches instead of cm, it does not make the measured "object" any smaller - or larger.  

Latest Update 11-8-2015

With the slowdown in the Chinese economy, the Chinese currency, the Yuan or also called Renminbi, is being devalued.  The USD appears to have reached a peak, which suggests that it will soften henceforth. We may just see the start of it, right now.We can also observe early signs of a gold price rally, just what you would expect when the dollar takes a breather. But will it continue if the FED goes ahead with the rate increase in September?

A couple of questions for the learned: What exactly should disturb global stock markets so much about the Yuan depreciation? Does a 2% Yuan adjustment warrant 4% losses in global assets? And - why did stock markets move unperturbed while the Euro - and the Yen fell by 10 times that much? I argued above that the battle is between the Euro and the USD. Could it be that the YUAN is the greater adversary for the USD because US politicians still view China as the greatest threat? Threats still work a treat in politics - and business.

The Three + One Steps To Misery

1. Economic recovery leads to a stronger currency, at least in the US. It is not unwelcome when the economy is booming. Indeed, it is seen as an indication of a strong economy. 
2. When the economy is in danger of "overheating", central banks act to slow it down, by raising interest rates. They say "we are cautiously optimistic". 
3. Any interest rate increase will push the currency higher and people start to think of saving. Money flows into the stronger dollar. Talked-up by foreign and local demand, the currency is viewed as safe haven with upside potential.  "Buy now". The currency is on a "bull run".
4. Additional rate increases will drive the currency too high, creating trouble for the export industry and subsequently in the rest of the economy. We are on the path to a recession.

The lesson here is that it can take several steps to build a sound economy and only one too many (rate hikes) to fall into recession.

War Tactics 

Investors

When interest rates rise in one currency, investors of a different currency often switch to the one with higher interest rates. They want more interest for their money. 

On an institutional level, even small differences in interest can make a drastic difference to their bottom lines, especially when using margin accounts. A favourite strategy is "carry-trade".  A "carry-trade" is basically borrowing money in a currency with low interest and invest into another with higher interest. An example from the past: borrowing Yen and invest in AUD.  The interest rate for YEN was near enough 0% for decades, while Australia and AUD was enjoying ever greater successes during the commodity boom. 

Not only did it offer the extra interest, there was always a chance for "capital gain" as a result of the stronger currency growing still stronger and/or the weaker currency getting weaker still as we saw with USD falling during QE1 and 2.

Central Banks

Raising interest rate to slow down a booming economy is but one way to apply fiscal control. If the slowdown is successful, then the economy continues along a gradual path of growth.  A rate increase too many can lead to an abrupt contraction in the economy, a sharp rise in unemployment and so on. The health of an economy is at the mercy of fiscal skills and sound assessment of our politicians. 

Importing Deflation, Exporting Inflation?

From a US point of view, goods from overseas have become cheap in recent months. The risk of inflation is greatly reduced, - and there should therefore be less pressure to raise interest rates. Do foreign imports result in an import of deflation into the US? It is an argument among some economists.  The danger of deflation would be greater if the US economy were to slow down.

Does the US export inflation?  Due its size and impact on global economies we can see such effects especially in rising food prices, transport and property prices in emerging economies and especially in Asia, where currencies have been weak by comparison. 

Similar assessments are made by other central banks and governments and each one has its own ideas on how to strike a balance.

The consumer

A stronger currency allows the consumer to buy goods elsewhere for less. If he has got the money, then he seems to have a distinct advantage. If however he needs to borrow then he will find that his debts, though nominally the same, go up in purchasing value, - and as a result of rising interest rates. 

How long such a price advantage will last depends how the demand affects supply. Theoretically, prices should increase over time and thus negate that advantage at some point. But, a lot of factors and politics can influence the outcome.  It is important to understand that such an advantage is often the result of an artificial imbalance created by fiscal policies and monetary intervention by the governments.  Left to market forces, such imbalances will be corrected sooner rather than later.

Toward the End Game

Mistakes in managing currencies inevitably lead to substantial losses. When interest rates get too high, too low, rise too early or too late, stock markets often respond with exaggerated moves. Market volatility occurs also on the way to the economic peaks, but it often finds its way back into the uptrend quite soon. 

After reaching the peak, however, any wrong move will accelerate a market correction. Are we at an economic peak now?  No, but stock markets in the US have been rallying strongly in anticipation for the last couple of years, some say since 2009. Yet, the economy is still far from peak levels. We should not assume that economies follow a straight pattern of recovery - growth - peak - decline - recession without experiencing considerable stock - and bond - market volatility, especially during a currency war!  

Is the FED right in raising interest rates in September?

I daresay, yes, mainly because keeping interest rates at 0.25% is not the best way to exercise fiscal controls.  

How will it affect markets?

• The USD should strengthen (interest rates will become higher than in Europe, Japan). 
• Unless the US economy is completely self-sustained, a stronger dollar will impact on company earnings from overseas, curb exports, curb manufacturing as demand drops. 
• Pretty soon, the stock market will need to correct, bond prices will fall and we are entering a period of "unintended consequences".

I call it that because people's expectations will dictate the stock market moves, not just economic data.  And in the current environment, events in China and Europe are adding to concerns, maybe more so than in the last 3 years. 

The End 

At least, stock markets should see a sizeable correction. Whether or not this is followed by an economic recession in the US and globally depends pretty much on FED policies - and how they communicate it. In the best scenario, we will experience a "soft landing", i.e. the economy slows but avoids a recession and rebuilds from there. The worst case scenario would be a "hard landing", something that has been persistently "predicted" for the Chinese economy but has failed to materialise so far due to shrewd government measures. 

I am not so confident about the FED, delivering flawless measures, and bemused that Trump is just the tiniest of tips of a US iceberg of blunderers, which will surely lead to economic and political mayhem.