February 11, 2013
“Currency War” is the latest hot title. It’s now on the front pages, triggered by the policy change in Japan. In only two months the Japanese yen has weakened about 15% against the US dollar.
Let’s reflect on this important development.
First, a simple case study. Suppose there were just two countries and just two currencies. Suppose country A decided to try to weaken its currency so it could sell more stuff at cheaper prices to country B, thus undercutting B’s domestic producers. B could resist by raising a tariff on the incoming stuff that A was trying to sell. Or it could retaliate by cheapening its own currency to counter the price differential. The first form of retaliation is a trade war; the second is a classic currency war. The economic history of the 1930s is replete with examples of each and combinations of both. History shows us that the results were disastrous for the global economy and led to a world war.
But is there a third alternative? What about the role of interest rates?
Suppose A announced that it wanted to weaken its currency by 5% against the currency of B. Furthermore, suppose A said it would do so over the course of one year. Then A proceeded to print more currency and use it to buy B’s currency, changing the exchange rate between A and B. Now let’s assume that B knew from earlier experience that retaliation would only lead to war, so B decided to do nothing. B also knew that in the longer term its citizens would benefit from a stronger currency, and B was confident enough and self-sufficient enough to allow A to cheapen itself for short-run gain. By doing nothing, B allowed the markets to make an adjustment. Suppose, also, that interest rates were not influenced by central banks’ actions. The markets would quickly price a 5% spread in the interest rate. At the one-year target maturity, the interest rate on debt denominated in currency A would be 5% higher than the rate on equivalent debt denominated in currency B. In a normal, clearing market, that is the way the adjustment occurs.
Japan is the leading candidate for the role of country A, given the policy changes announced and those still to come. The rest of the world is trying to figure out how to be a country B while being savvy enough to avoid deterioration into a trade war or currency war.
In our modern world there are more than two currencies. Four of them make up the bulk of the world’s reserves. The US does not hold much reserve in foreign currency; instead, the US dollar is the dominant reserve choice of the others. US dollars amount to about 60% of the world’s reserves and the euro about 25%. The yen and the pound are each about 4%. Add in a little gold, and you have tallied most of the world’s reserves. The rest of the countries are nice places to visit, but their currencies are bit players in terms of global impact.
Since November, one of the major (G4) currencies, Japan, has dramatically changed policy. Furthermore, Japan has directed its change in a way that causes another G4 currency, the euro, to strengthen. This action and ensuing reaction has triggered energetic discussion of a possible currency war.
Will we see one? Maybe. Are the currency moves we are seeing volatile and abrupt enough to ignite one? Yes.
The reason we’re on the brink of a currency war is that the central banks of the G4 have taken their policy interest rates to near zero. By doing so, they have collectively reduced the ability of market forces to adjust interest rates in response to the policy changes.
Let’s go back to our two-country example to see how this works. In our simplified model, interest rates were the adjusting mechanism. They were permitted to work when B decided not to engage in a policy change in response to A.
But what would have happened if the central banks of both A and B had taken their interest rates down to the near-zero boundary? And if, furthermore, A and B had committed to this policy because their respective economies were now attempting to recover from serious recessionary or deflationary damage? In this situation, interest-rate changes could no longer offset the exchange-rate mechanism. That is the outcome when the interest rates are managed by central banks. The normal market clearing forces cease to work. Instead, we get currency exchange-rate moves that deliver jolts to economies – bumps in a road that must be driven without shock absorbers. That is what happens when the mitigating effects of interest-rate changes are removed from the equation.
The world now finds itself in this position in response to the Japanese policy change. Here is a quick inventory of the G4.
Japan is committed to a weaker currency and to further central bank balance-sheet expansion. It is trying to get its economy to grow, and it is targeting an increase in inflation to 2%. Some forecasts expect the yen to reach 110 to 115 against the dollar within a year.
Meanwhile, the UK is trying to avoid a triple-dip recession. Expectations are that it, too, will engage in another round of monetary easing. We shall learn more as its new central bank governor gets established. With certainty, the UK will not tighten any time soon. Its short-term interest rate will hover at the near-zero boundary. And no one knows where the pound will trade as this next round of policy moves unfolds.
The US is likewise following its announced central bank balance-sheet expansion. The Federal Reserve affirmed that policy only a few days ago. Fed Vice-chair Janet Yellen reaffirmed it today. The Fed’s target for unemployment is 6.5%. (Currently the unemployment rate is 7.9%.) We have several more years before the Fed’s target rate will be reached. The Fed’s inflation target is 2.5%, and the US is operating at a lower inflation rate. Thus US policy is predictable for a while. US policymakers ignore the exchange value of the US dollar in making their decisions. They may talk about it, but FX is not the driver of decisions. As long as the US dollar maintains its current status as the dominant reserve choice, our nation will continue a practice of benign neglect with regard to our currency exchange rate.
On the other side of the Atlantic, the euro is strengthening in spite of all the difficulties in Europe. It is the G4 default choice because of the Japanese initiative and because the US and UK are in easing mode, while the European Central Bank has just reduced its excess reserves with a policy-changing transaction. Now ECB President Mario Draghi is worrying about his action being too much, too soon. We may see the euro trade up in strength against the others in the G4. That will compound Europe’s economic slowdown.
Note that in all cases interest rates remain very low, and the tendency of the central banks is to continue and to enlarge quantitative easing. We track that trend weekly at www.cumber.com . Also note that the economies we have discussed are not growing with any robustness, subjected as they are, in most cases, to higher taxes and anti-growth policies.
We believe that fears of a huge sovereign debt collapse are in error and misplaced. While they may eventually be realized, they do not loom in the near future. Meanwhile, currency volatility is likely to rise.
Our bond portfolios are slowly adjusting duration. We are using some strategic hedging of interest rates where that fits within the account objectives.
The central banks have the power to keep interest rates low for a prolonged period. They also have the power to influence the currency exchange rate. They do not have the power to do both at the same time unless it is a coincidental policy. It is going to be an interesting decade.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Investments