Thursday, January 17, 2013

Prepare For a Global Currency War?

Earlier this week, Jeff Cox of CNBC wrote an interesting article, First Shots Are Fired in Global 'Currency War':
Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace. (Read More: Japan PM Says BOJ Must Set 2% Medium-Term Inflation Goal)

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

While respective countries would have their own versions, the moves would follow three years of aggressive bond buying from the Federal Reserve as part of its $3 trillion quantitative easing program.

Though critics worry about the long-term consequences, the three rounds of QE have managed to keep the U.S. economy afloat and have boosted risk assets such as stocks and commodities.

"Ever since the Fed launched QE2 in August 2010, we have been in the currency-war regime," said Alessio de Longis, portfolio manager of the Oppenheimer Currency Opportunities Fund. "It will continue to be this."

In a late-2012 announcement, outgoing Bank of Japan leader Masaaki Shirakawa indicated an aggressive easing program that would total 50 trillion yen over the next year or so.

The move is part of Abe's plan to get the country out of its two-decade deflationary spiral, but has generated mixed reaction.

"The economic policies of the new administration are set to be centered on loose monetary policy and fiscal pump-priming," Citigroup analysts said in a research note. "However, experience suggests this is unlikely to lead to a sustained revival of the Japanese economy."

Still, a declining yen would help Japanese exports and put upward pressure on other currencies, something unlikely to be tolerated by its competitors.

The massive Fed balance sheet expansion has resulted in the U.S. dollar declining about 11 percent against a basket of world currencies since QE began in 2009. In the meantime, stock prices have doubled since their March 2009 lows and the Morgan Stanley Commodity Related Index has gained about 80 percent.

With the U.S. as its guide, competitive devaluation is expected to accelerate.

Strategas investment strategist Jason Trennert included the "race to the bottom" as one of his five principle investment themes of the year.

"Recent actions on the part of the Fed, the ECB, the Bank of Japan, the Swiss National Bank, and the Bank of England all suggest that financial repression (or the perpetuation of negative real rates on sovereign debt) is likely to be the most enduring investment theme for the foreseeable future," Trennert said.

In 2012, global central banks cut interest rates some 75 times in an effort to create conditions that would spur growth.

Economists, though, expect growth to meander around 3 percent globally this year, a level generally considered to reflect little actual growth at all. (Read More: US Economy to Grow 2.5% This Year: Fed's Evans)

The hope, though, for those engaged in currency devaluation is that it cheapens the price of their goods globally and thus increases exports and creates positive inflation.

But the initial stages of inflation are usually bad for stocks and send investors to commodities and fixed income indexed for inflation, such as Treasury Inflation Protected Securities.

"So what could cause a market correction over the first half of 2013?" Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, said in an analysis. "In our view it will either be 1) a rapid rise in interest rates and a re-run of the 1994 story; or 2) the economy fails to respond to the liquidity, forcing nations to devalue their currencies in an attempt to stimulate growth."

The Standard & Poor's 500 slipped about 4 percent in 1994, losing ground through year as the Fed tightened policy to control the recovery. Of course, a major bull run began the following year, with the index soaring 32 percent in 1995.

Though the release of the most recent Fed minutes scared some investors into thinking the Fed might normalize rates sooner than expected, those fears since have been largely dismissed.

Other central banks around the world are likely to take note. (Read More: Has Draghi Won the Battle With Financial Markets?)

"It is clear that many nations want/need a weaker currency – should China also feel the need for a weaker (currency)...then the risks of a risk-negative (currency) war would start to grow," Hartnett said. "Gold would rally sharply, but note a rise in gold prices and a fall in bond prices precipitated the 1987 crash."

He advised clients to keep a close watch on the Chinese yuan and the broader Asian dollar index.

Oppeheimer's de Longis adds the Colombian peso to that list as well as the New Zealand and Australian dollars, with others in South America and Europe possibly joining as well.

He fears that while the short-term effects could be positive for those countries involved as well as the risk assets associated with such moves, the long-term consequences could be onerous.

"These policies are creating the preconditions for central banks around the world in, say, five to 10 years from now to ask, 'How do we shrink these balance sheets in an organized and gradual manner?'" de Longis said. "History tells us that these large experiments, especially on a global scale, don't end up being unwound in an orderly manner."
And Bloomberg reports that Russia is warning of a global currency war:
The world is on the brink of a fresh “currency war,” Russia warned, as European policy makers joined Japan in bemoaning the economic cost of rising exchange rates.

“Japan is weakening the yen and other countries may follow,” Alexei Ulyukayev, first deputy chairman of Russia’s central bank, said at a conference today in Moscow.

The alert from the country that chairs the Group of 20 came as Luxembourg Prime Minister Jean-Claude Juncker complained of a “dangerously high” euro and officials in Norway and Sweden expressed exchange-rate concern.

The push for weaker currencies is being driven by a need to find new sources of economic growth as monetary and fiscal policies run out of room. The risk is as each country tries to boost exports, it hurts the competitiveness of other economies and provokes retaliation.

Yesterday “will go down as the first day European policy makers fired a shot in the 2013 currency war,” said Chris Turner, head of foreign-exchange strategy at ING Groep NV in London.

The skirmish may lead to a clash of G-20 finance ministers and central banks when they meet next month in Moscow, three months after reiterating their 2009 pledge to “refrain from competitive devaluation of currencies.”

While emerging markets have repeatedly complained about strong currencies as a result of easy monetary policies in the west, the engagement of richer nations is adding a new dimension to what Brazilian Finance Minister Guido Mantega first dubbed a currency war in 2010.

After Switzerland blocked the franc’s appreciation against the euro since September 2011, Japan has reignited the latest round of rhetoric as newly elected Prime Minister Shinzo Abe campaigns to spur growth via a more aggressive central bank. The yen has slid 11 percent against the dollar since December and this week touched its lowest level in two years.

Now other policy makers are speaking out. Juncker, who leads the group of euro-area finance ministers, said yesterday that the euro’s 7 percent gain against the dollar in the past six months poses a fresh threat to the European economy just as it shows signs of escaping its three-year debt crisis.

While the euro fell, the power of his words may be limited by signals from the European Central Bank that it isn’t prepared to favor a weaker currency. ECB President Mario Draghi last week said he has no goal for the exchange rate, although he noted the euro was trading at its long-run average.

The euro exchange rate is “not a major concern,” ECB council member Ewald Nowotny told reporters in Vienna today.

“For us, the exchange rate of the euro is one variable to be factored in, but isn’t a goal in itself,” ECB Executive Board member Peter Praet told La Libre Belgique newspaper in an interview published today.

Still, economists at Goldman Sachs Group Inc. and Citigroup Inc. said in reports today that a further strengthening of the euro could eventually help trigger an interest-rate cut from the ECB.

In Norway, Finance Minister Sigbjoern Johnsen said in an interview that a strong krone challenges the economy and that the government must ease pressure on the Norges Bank to avoid krone strengthening by conducting a “tight” fiscal policy. Norges Bank Deputy Governor Jan F. Qvigstad said yesterday that if the krone remains strong until policy makers meet in March, “that of course has an obvious effect on the interest rate.”

That pushed the currency, which has emerged as a haven from the European crisis, to its lowest level in more than two months versus the euro.

Meantime, Riksbank Deputy Governor Lars E. O. Svensson said today that a strong Swedish krona would be “yet another reason” to lower borrowing costs. He last month argued for a deeper cut than the 0.25 percentage point move to 1 percent that colleagues supported.

“It’s obvious that the economy would manage better in this very difficult, weak economy with a lower rate and a weaker krona,” Svensson said in Stockholm.

Elsewhere, Bank of Korea Governor Kim Choong Soo said Jan. 14 that a steep drop in the yen could provoke an “active response to minimize any negative impacts on exports and investor confidence.” Vice Finance Minister Shin Je Yoon said today that South Korea wants the G-20 talks in Moscow to focus on adverse effects of monetary easing in the U.S., Europe and Japan.

If Japan continues to pursue a softer currency, reciprocal devaluations would hurt the global economy, Russia’s Ulyukayev said today. That echoes recent concern from other international policy chiefs.

Federal Reserve Bank of St. Louis President James Bullard said Jan. 10 that he’s “a little disturbed” by Japan’s stance and the risk of “beggar-thy-neighbor” policies.

Reserve Bank of Australia Governor Glenn Stevens said Dec. 12 that there is a “degree of disquiet in the global policy- making community,” while Bank of England Governor Mervyn King said Dec. 10 that he worried “we’ll see the growth of actively managed exchange rates.”
So will there be a global currency war? In November, I warned my readers to prepare for a seismic shift in Japan, stating they will do everything in their power to fight the ongoing deflationary headwind. Since then, the yen has slid and the Nikkei has rallied sharply.

But will Japan successfully engineer higher inflation? That remains to be seen. I have my doubts and so do many others, including Pimco's Mohamed El-Erian. Michael Gayed of Pension Partners tweeted this to me in an exchange we had last night:
...my point is that there is a level and speed where a falling Yen becomes very damaging. If cost-push inflation happens. I'm not sure pricing power among the aging Japanese population is that strong.... The ratio trend is still up (on the EWJ) but I think the trade is too one-sided. No one talking about negatives. 
I think there are limits to currency wars and at the end of the day, the Fed holds the biggest stick, not China, Japan or rest of the BRICs. Go back to read my last comment of 2012 on the new depression to understand why this is so.

Talk of currency wars makes for sensational news articles and allows gold shills and hyper-inflationistas on Zero Edge to thump their chest, but take these articles with a grain of salt. Seen this many times in the last 16 years and it typically turns out to be nothing (only real winners are currency traders).

On currencies, spoke to a buddy of mine yesterday who trades currencies for a living. Told him I'm long the USD because I think US growth will surprise to the upside and recommended to start shorting the CAD because of Canada's perfect storm. He told me to wait shorting the CAD until the loonie reaches 95 cents as the Nexen merger is CAD bullish until it is finalized and he agreed with me on the USD. On the euro, he told me he's is looking to short it at 1.32

Below, Henry McVey, head of global macro & asset allocation at KKR & Co., says he expects a very slow first half of 2013, but a rebound in the second half. Forget currency wars, watch this interview, it's excellent. Mr. McVey is a very sharp guy and I agree with his views.