"Beggar Thy Neighbor" Is Back: Goldman's Five Things To Watch As Currency Wars Return

"We’re seeing a new era of currency wars," Neil Mellor, a foreign-exchange strategist at Bank of New York Mellon in London. This is what Bloomberg reported today in a piece titled "Race to Bottom Resumes as Central Bankers Ease Anew." It adds: "The global currency wars are heating up again as central banks embark on a new round of easing to combat a slowdown in growth.  The European Central Bank cut its key rate last week in a decision some investors say was intended in part to curb the euro after it soared to the strongest since 2011. The same day, Czech policy makers said they were intervening in the currency market for the first time in 11 years to weaken the koruna. New Zealand said it may delay rate increases to temper its dollar, and Australia warned the Aussie is “uncomfortably high."

For the most part Bloomberg's account is accurate, although it has one fundamental flaw: currency wars never left, but were merely put on hiatus as the liquidity tsunami resulting from the BOJ's mega easing lifted all boats for a few months. And now that the world has habituated to nearly $200 billion in new flow every month (and much more when adding China's monthly new loan creation), the time to extract marginal gains from a world in which global trade continues to contract despite the ongoing surge in global liquidity, central banks are back to doing the one thing they can - printing more.

The moves threaten to spark a new round in what Brazil Finance Minister Guido Mantega in 2010 called a “currency war,” barely two months after the Group of 20 nations pledged to “refrain from competitive devaluation.”


“There are places in the world where economies are generally quite weak, where inflation is already low,” Alan Ruskin, global head of Group-of-10 foreign exchange in New York at Deutsche Bank AG, the world’s largest currency trader, said in a Nov. 8 phone interview. “Japan was in that mix for 20-odd years. Nobody wants to go there” and “the talk from Draghi shows they’re taking the disinflation story very seriously. The Czech Republic is the same story.”


Growth in global trade may slow to 2.5 percent in 2013, the new head of the World Trade Organization said after a Sept. 5-6 summit of G-20 nations in St. Petersburg, Russia, down from the organization’s previous estimate in April of 3.3 percent. Even so, the G-20 participants agreed to “refrain from competitive devaluation” and not “target our exchange rates for competitive purposes.”

It is indeed the bolded part that is the most disturbing one, and is why the most important revision in the IMF's quarterly update of its flawed forecasts, is always the chart showing the collapse in real global trade, which in 2013 is now forecast to be 50% lower than preliminary estimates.

So what should one watch for now that even the MSM admits the currency wars are "back"? Goldman lists the 5 key areas to watch as central banks resume beggar thy neighbor policies with never before seen vigor.

  • Watch for Sudden Policy Shifts – In a regime where stability is achieved via offsetting forces, a sudden change in one of these forces will lead to potentially rapid moves. Changes often result from a major policy shift, as for example seen in Japan about a year ago. The period of Sterling weakness early in the year was another example, where a central bank suddenly increased the focus on the exchange rate. A policy shift that hurt EM deficit currencies this year, in particular, was the move towards Tapering by the Fed. Changes to one of the normally offsetting forces are quite similar to revaluation or devaluations in traditional exchange rate regimes.
  • Watch Genuine Appreciation Trends – In a world where every country wants to prevent its currency from strengthening, those who actually favour a stronger currency will not face many offsetting pressures. Obviously this is conditional on stronger underlying fundamentals. In order to control the speed of appreciation, frequent smoothing operations can be necessary. This may create a scenario of relatively slow appreciation, combined with very low volatility, which in turn would imply a high Sharpe Ratio. China’s steady Renminbi appreciation remains a case in point. And in recent times the Korean Won as well.
  • Watch Policy Constraints – There may also be countries that face continued appreciation pressures but operate under policy constraints that do not allow them to respond fully. In these situations policymakers may not be able to fully prevent appreciation. The constraints could appear in various forms. Would the ECB have been able to cut rates with higher inflation rates? A strict inflation mandate reduces the flexibility for policy makers to respond to currency movements, in particular when they reflect positive growth shocks. External policy pressures could be a constraint. The discussions at the G7 may have been a factor that limited Japan’s ability to weaken the JPY further and could become a constraint in case the JPY starts to strengthen again. The US Treasury report on currencies certainly hints in that direction.
  • Watch Carry – If policymakers aim at anchoring the exchange rate in nominal terms and succeed, this does not automatically imply that there are no return opportunities. As long as interest rates differentials persist there will be carry opportunities. And again relatively low volatility may be a welcome feature which raises Sharpe ratios. How long will the RBA be able to sustain an interest rate differential of more than 2% to most other developed economies in such a scenario?
  • Watch Quasi Currencies – Finally there is even an argument that competitive devaluations could boost precious metals. That view is based on the simplification that gold, for example, is a “homeless” currency without a central bank that tries to block its appreciation. Another way of saying the same is that many asset prices may rise in response to continued and competitive monetary easing, which is a key feature of such a non-collaborative exchange rate mechanism.

But most importantly, watch Yellen and the inflection point where the consensus that tapering may/will/should be just around the corner, makes way for the anathema, namely that $85 billion per month is nowhere near enough as the Fed doubles down on its own core prerogative for 2014: ramping inflation at all costs... even if it means a return to Yellen's favorite topic: outright monetary finance.


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