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2012-10-09 07:22:50
New government priorities and an enthusiasm for unconventional monetary policy
are changing the way the currency markets work
Oct 6th 2012 | from the print edition
OVER most of history, most countries have wanted a strong currency or at least
a stable one. In the days of the gold standard and the Bretton Woods system,
governments made great efforts to maintain exchange-rate pegs, even if the
interest rates needed to do so prompted economic downturns. Only in exceptional
economic circumstances, such as those of the 1930s and the 1970s, were those
efforts deemed too painful and the pegs abandoned.
In the wake of the global financial crisis, though, strong and stable are out
of fashion. Many countries seem content for their currencies to depreciate. It
helps their exporters gain market share and loosens monetary conditions. Rather
than taking pleasure from a rise in their currency as a sign of market
confidence in their economic policies, countries now react with alarm. A strong
currency can not only drive exporters bankrupt a bourn from which the
subsequent lowering of rates can offer no return it can also, by forcing down
import prices, create deflation at home. Falling incomes are bad news in a debt
crisis.
Thus when traders piled into the Swiss franc in the early years of the
financial crisis, seeing it as a sound alternative to the euro s travails and
America s money-printing, the Swiss got worried. In the late 1970s a similar
episode prompted the Swiss to adopt negative interest rates, charging a fee to
those who wanted to open a bank account. This time, the Swiss National Bank has
gone even further. It has pledged to cap the value of the currency at SFr1.20
to the euro by creating new francs as and when necessary. Shackling a currency
this way is a different sort of endeavour from supporting one. Propping a
currency up requires a central bank to use up finite foreign exchange reserves;
keeping one down just requires the willingness to issue more of it.
When one country cuts off the scope for currency appreciation, traders
inevitably look for a new target. Thus policies in one country create ripples
that in turn affect other countries and their policies.
The Bank of Japan s latest programme of quantitative easing (QE) has, like most
of the unconventional monetary policy being tried around the world, a number of
different objectives. But one is to counteract an unwelcome new appetite for
the yen among traders responding to policies which have made other currencies
less appealing. Other things being equal, the increase in money supply that a
bout of quantitative easing brings should make that currency worth less to
other people, and thus lower the exchange rate.
Ripple gets a raspberry
Other things, though, are not always or even often equal, as the history of
currencies and unconventional monetary policy over the past few years makes
clear. In Japan s case, a drop in the value of the yen in response to the new
round of QE would be against the run of play. Japan has conducted QE programmes
at various times since 2001 and the yen is much stronger now than when it
started.
Nor has QE s effect on other currencies been what traders might at first have
expected. The first American round was in late 2008; at the time the dollar was
rising sharply (see chart). The dollar is regarded as the safe haven
currency; investors flock to it when they are worried about the outlook for the
global economy. Fears were at their greatest in late 2008 and early 2009 after
the collapse of Lehman Brothers, an investment bank, in September 2008. The
dollar then fell again once the worst of the crisis had passed.
The second round of QE had more straightforward effects. It was launched in
November 2010 and the dollar had fallen by the time the programme finished in
June 2011. But this fall might have been down to investor confidence that the
central bank s actions would revive the economy and that it was safe to buy
riskier assets; over the same period, the Dow Jones Industrial Average rose
while Treasury bond prices fell.
After all this, though, the dollar remains higher against both the euro and the
pound than it was when Lehman collapsed. This does not mean that the QE was
pointless; it achieved the goal of loosening monetary conditions at a time when
rate cuts were no longer possible. The fact that it didn t also lower exchange
rates simply shows that no policies act in a vacuum. Any exchange rate is a
relative valuation of two currencies. Traders had their doubts about the
dollar, but the euro was affected by the fiscal crisis and by doubts over the
currency s very survival. Meanwhile, Britain had also been pursuing QE and was
slipping back into recession. David Bloom, a currency strategist at HSBC, a
bank, draws a clear lesson from all this. The implications of QE on currency
are not uniform and are based on market perceptions rather than some
mechanistic link.
In part because of the advent of all this unconventional monetary policy,
foreign-exchange markets have been changing the way they think and operate. In
economic textbooks currency movements counter the differences in nominal
interest rates between countries so that investors get the same returns on
similarly safe assets whatever the currency. But experience over the past 30
years has shown that this is not reliably the case. Instead short-term nominal
interest-rate differentials have persistently reinforced currency movements;
traders would borrow money in a currency with low interest rates, and invest
the proceeds in a currency with high rates, earning a spread (the carry) in the
process. Between 1979 and 2009 this carry trade delivered a positive return
in every year bar three.
Now that nominal interest rates in most developed markets are close to zero,
there is less scope for the carry trade. Even the Australian dollar, one of the
more reliable sources of higher income, is losing its appeal. The Reserve Bank
of Australia cut rates to 3.25% on October 2nd, in response to weaker growth,
and the Aussie dollar s strength is now subsiding.
So instead of looking at short-term interest rates that are almost identical,
investors are paying more attention to yield differentials in the bond markets.
David Woo, a currency strategist at Bank of America Merrill Lynch, says that
markets are now moving on real (after inflation) interest rate differentials
rather than the nominal gaps they used to heed. While real rates in America and
Britain are negative, deflation in Japan and Switzerland means their real rates
are positive hence the recurring enthusiasm for their currencies.
The existence of the euro has also made a difference to the way markets
operate. Europe was dogged by currency instability from the introduction of
floating rates in the early 1970s to the creation of the euro in 1999. Various
attempts to fix one European currency against each other, such as the Exchange
Rate Mechanism, crumbled in the face of divergent economic performances in the
countries concerned.
European leaders thought they had outsmarted the markets by creating the single
currency. But the divergent economic performances continued, and were
eventually made manifest in the bond markets. At the moment, if you want to
predict future movements in the euro/dollar rate, the level of Spanish and
Italian bond yields is a pretty good indicator; rising yields tend to lead to a
falling euro.
The reverse is also true. Unconventional interventions by the European Central
Bank (ECB) over the past few years might have been expected to weaken the
currency, because the bank was seen as departing from its customary hardline
stance. They haven t because they have normally occurred when the markets were
most worried about a break-up of the currency, and thus when the euro was
already at its weakest. The launch of the Securities Market Programme in May
2010 (when the ECB started to buy Spanish and Italian bonds), and Mario Draghi
s pledge to do whatever it takes , including unlimited bond purchases, in July
2012 were followed by periods of euro strength because they reduced fears that
the currency was about to collapse.
Currency war, what is it good for?
Currency trading is, by its nature, a zero-sum game. For some to fall, others
must rise. The various unorthodox policies of developed nations have not caused
their currencies to fall relative to one another in the way people might have
expected. This could be because all rich-country governments have adopted such
policies, at least to some extent. But it would not be surprising if rich-world
currencies were to fall against those of developing countries.
In September 2010 Guido Mantega, the Brazilian finance minister, claimed that
this was not just happening, but that it was deliberate and unwelcome: a
currency war had begun between the North and the South. The implication was
that the use of QE was a form of protectionism, aimed at stealing market share
from the developing world. The Brazilians followed up his statement with taxes
on currency inflows (see Free Exchange).
But the evidence for Mr Mantega s case is pretty shaky. The Brazilian real is
lower than it was when he made his remarks (see chart). The Chinese yuan has
been gaining value against the dollar since 2010 while the Korean won rallied
once risk appetites recovered in early 2009. But on a trade-weighted basis
(which includes many developing currencies in the calculation), the dollar is
almost exactly where it was when Lehman Brothers collapsed.
Many developing countries have export-based economic policies. So that their
currencies do not rise too quickly against the dollar, thus pricing their
exports out of the market, these countries manage their dollar exchange rates,
formally or informally. The result is that loose monetary policy in America
ends up being transmitted to the developing world, often in the form of lower
interest rates. By boosting demand, the effect shows up in higher commodity
prices. Gold has more than doubled in price since Lehman collapsed and has
recently reached a record high against the euro. Some investors fear that QE is
part of a general tendency towards the debasement of rich-world currencies that
will eventually stoke inflation.
The odd thing, however, is that the old rule that high inflation leads to weak
exchange rates is much less reliable than it used to be. It holds true in
extreme cases, such as Zimbabwe during its hyperinflationary period. But a
general assumption that countries with high inflation need a lower exchange
rate to keep their exports competitive is not well supported by the evidence
indeed the reverse appears to be the case. Elsa Lignos of RBC Capital Markets
has found that, over the past 20 years, investing in high-inflation currencies
and shorting low-inflation currencies has been a consistently profitable
strategy.
The main reason seems to be a version of the carry trade. Countries with
higher-than-average inflation rates tend to have higher-than-average nominal
interest rates. Another factor is that trade imbalances do not seem to be the
influence that once they were. America s persistent deficit does not seem to
have had much of an impact on exchange rates in recent years: nor does Japan s
steadily shrinking surplus, or the euro zone s generally positive aggregate
trade position.
In short, foreign-exchange markets no longer punish things that used to be
regarded as bad economic behaviour, like high inflation and poor trade
performance. That may help explain why governments are now focusing on other
priorities than pleasing the currency markets, such as stabilising their
financial sectors and reducing unemployment. Currencies only matter if they get
in the way of those goals.
from the print edition | Briefing