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The weak shall inherit the earth

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