Currency Wars

May 9, 2013

Two themes are dominating currency market life.  One is disinflation.  A funny thing happened on the way to the widely predicted explosion of inflation that market players feared would be the result of fiscal deficit spending and rapid growth in central bank balance sheets.  Inflation rates have instead decelerated and been negative in a few cases like Japan and Switzerland. Disinflation from low levels is not a desirable development.  Japanese voters made a political regime change, endorsing new leadership that has offered a no-holds-barred counterattack on deflation as its top priority.  Fed officials increasingly cite lower-than-mandated inflation to justify $85 billion of quantitative easing each month, and the ECB took a few easing steps this month because of a downwardly revised prognosis for inflation. 

The other theme concerns real and imagined currency warfare.  Policies of competitive depreciation have been nowhere near as blatant as those in the 1920s and 1930s.  Japan’s government has committed the most provocative actions during the past six months but was given a thumbs up by G20 leaders attending last month’s meeting, who concluded that Japanese policy changes to extinguish toxic deflation were warranted even if substantial yen depreciation occurs as a result.  In subsequent weeks, however, various other governments have taken their own initiatives to lessen the collateral damage of a weak yen, that remains ongoing. 

  • New Zealand’s central bank sold New Zealand dollars, the first currency market intervention by that country in some five years.
  • In the Pacific Rim, the Bank of Korea, Reserve Bank of Australia, and Reserve Bank of India each cut interest rates this past week.
  • The European Central Bank also cut an interest rate but failed to get ahead of the curve of market perceptions that it has and will continue to do less than other central banks to promote domestic demand and expedite the road back to recovery.

None of such was enough to halt the downward trend in the yen, which today finally catapulted over the 100 per dollar level — at least for a while.  In the meantime, Japan’s currency is also weaker than 130 per euro, which has become a round level against which the EUR/JPY cross rate is being judged.

Whereas the yen seems weak from the vantage point of a half-year ago, comparisons of a longer duration yield a different perspective.  It happens that today marks exactly 50 months since U.S. share prices, and those of many other countries, bottomed during the Great Recession.  Since March 9, 2009, the DOW, S&P 500, and Nasdaq indices have advanced by 131%, 141% and 170%.  A 124% revival of the German Dax has been only slightly less than those moves, but the Japanese Nikkei’s 100% rise lags even further.  Among ten-year sovereign bond yields, the ranking for net declines over this period shows German bunds at 167 basis points, U.S. Treasuries at 107 bps and Japanese JGBs further back in the pack at 71 bps. 

In the macroeconomic backdrop, economic growth in Euroland has been less than a fourth as much as net growth in the United States and Japan.  Unlike the U.S. and Japan, Europe is in recession now as well as four years ago.  Among the three economies, only the U.S. level is now above its pre-recession peak, and analysts expect U.S. growth in 2014 to be twice as high as in Japan and three times greater than in the Euro area.  Another development of note is the emergence of a chronic Japanese trade deficit, but Japan’s current account surplus, like Euroland’s, should exceed 1% of GDP next year and stand in contrast to a U.S. deficit of nearly 3% of GDP.

A static equilibrium analysis of the dollar now compared to early March 2009 finds currency markets clearing at almost identical price levels.  The dollar is just 0.2% softer now than its close on March 9, 2009, and dollar/yen shows a net appreciation of just 1.6%.  That equilibrium is possible under vastly different macro and financial circumstances highlights the sensitivity of currency markets to perceived government preferences and sets up an interesting challenge as those currency desires seem headed for greater conflict.  To sustain Japan’s recovery of GDP and asset prices, the Abe government needs to have the yen trend at least modestly lower.  The United States needs greater support from net exports to compensate for fiscal drag.  Commodity-sensitive currencies haven’t weakened in a consistent way with the softer performance of world commodities.  Gold shows a gain of 59% over the last 50 months, well short of the concurrent advance in stock prices.  The stakes are highest for the ECB, where failure to achieve recovery with price stability that is defined as below but close to 2% consumer price inflation could upset the whole common currency experiment.  Euroland will critically need export competitiveness, and a weaker euro is going to be hard to deliver if monetary officials drag their feet on taking substantial action to promote growth.

The final irony is that all currencies cannot depreciate at the same time.  Currency wars, like other price wars, are best avoided, because they usually hurt everyone and benefit nobody for more than the short run.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

Tags: , , ,


Comments are closed.