WISE MONEY

Dominique Strauss-Kahn the IMF’s Managing Director said co-operation between countries had weakened since the financial crisis started in 2008.The Fed’s policies have led to a wave of money-seeking opportunities in the emerging economies. That tends to push their currencies up, undermining their competitiveness.

There is also the risk of bubbles in financial and property markets. And capital inflows can go into reverse – as they did in the Asian crisis in the 1990s.

So the third element in the currency “war” is the resistance of emerging economies, and some developed ones too.

Brazil and Thailand have used tax measures to slow the inflows. Japan, South Korea and others have intervened in the currency markets, buying foreign currency in an attempt to interrupt the rise of their own.

There is a view that they will just have to live with it. The upward pressure on the currencies of many emerging economies reflects the fact they are more growing strongly than the US.

It is difficult for them to manage, but the underlying reason is that they are doing relatively well.

The currency war is closely linked with another theme that has been troubling many economists for several years, that of global economic imbalances.

In international terms, it is trade that is unbalanced. Actually, the thing that is most often the focus is the “current account balance”, which means trade in goods and services plus some financial items, including remittances that migrant workers send home.

Usually, though, trade is responsible for most of the current account imbalance.

Some countries have large trade surpluses, notably China, Germany, Saudi Arabia and Russia. The biggest deficit country is the United States.

Some countries at the eye of the European storm have hefty deficits too – the PIGS aka Portugal, Ireland, Greece and Spain.

Britain also has a deficit, although as a share of national income, it is not all that large.

The other side of international imbalances is high savings at home with a surplus country such as China, and relatively low savings in a deficit country such as the US.

Household savings have risen in the US, the UK and other deficit countries, because consumers are borrowing less in the wake of the financial crisis.

But international imbalances also reflect how much governments borrow and in many deficit countries that has risen, partly offsetting the increase in private savings.

Why does all this matter? Those countries where saving has risen desperately want to export more. They want to sell more abroad to make up for consumers at home drawing cutting back their consumption.

That is true of the US, Britain and many others. They could do that more easily if consumers in China and the other surplus countries were willing to buy more imported goods.

A rise in China’s currency would not be a cure all, but it would probably help in the short term. Although it would also create greater inflation.

It has been called a “currency war”, by the International Monetary Fund’s managing director and the Brazilian finance minister among others.
IMF chief Dominique Strauss-Kahn warned that there were signs that countries were trying to use their currencies “as a weapon”.

For his part, Brazil’s Guido Mantega said competitive devaluations by advanced countries amounted to a new trade war.

“We’re in the midst of an international currency war,” he told a meeting of industrial leaders in September. “This threatens us because it takes away our competitiveness.”

There are three key elements, two of them fairly new, but the first is a long standing one.

It is China’s policy of managing its currency and limiting its movement against the US dollar.

It has been though several phases and during the financial crisis, China went back to keeping the yuan from rising.
Clerk counting 100-yuan notes China is trying to hold the yuan’s value down

Since just before the Toronto G20 summit in June, it has eased the controls and allowed the currency to move up against the dollar, but by less than 2.5% (as of now). And because the dollar has fallen, the yuan has dropped against many other currencies as well.

The reason for the Chinese reluctance to allow the yuan to rise much is a fear of job losses among export industries that would be made less competitive.

The rise against the dollar has not been enough to satisfy the US, where there is a long standing complaint that China manipulates its currency to gain an unfair advantage. The cry is: “It costs American jobs.”

Many in the US complain about China, but they are not innocent either.

The dollar has fallen sharply in recent months, because interest rates are low, so investors have been seeking higher returns in emerging economies.

They need to buy the currency of the country concerned to make those investments. That tends to push its value up, while the dollar, which they are selling, tends to fall.

And the effect is aggravated by the Federal Reserve’s other policy, known as quantitative easing. The Fed buys financial assets and the money it pays with has to be invested somewhere.

The weak dollar has an advantage for the US – it’s that competitiveness issue again. It should help American exporters.

The US has a large trade deficit, so more exports could help fix that. Many argue that the Fed’s policies are actually intended to weaken the dollar and help the US economy recover by exporting more.

The Fed’s policies have led to a wave of money-seeking opportunities in the emerging economies. That tends to push their currencies up, undermining their competitiveness.

There is also the risk of bubbles in financial and property markets. And capital inflows can go into reverse – as they did in the Asian crisis in the 1990s.

The gap between what is promised before a G20 finance meeting and what is announced afterwards seems to be growing.The theme at this meeting was, unsurprisingly, currencies and specifically how to stop nations engaging in beggar-thy-neighbour competitive exchange rate devaluations, to keep exports cheap in the face to falling domestic demand.

This path would be disastrous for world trade and global growth in general, which need stability to allow goods, services and capital to flow freely from country to country.

What was agreed by the G20 was that the scenario above would not be allowed to happen, but the agreement stopped short of actual commitment.

The US proposed that export surpluses be capped at 4% of GDP, a sensible idea, but the current global imbalances mean that is about as likely to happen as the G20 coming up with a concrete commitment on anything.

Although it is disappointing that nothing solid was agreed, the news is generally positive and has helped stocks to gain in nearly trading and the Dollar and Euro to gain against the Pound.

The US seems satisfied that China will allow the Yuan to appreciate and it now looks unlikely that the punitive import taxes the US were threatening to slap on Chinese exports will go ahead.

Sterling has opened up the week on the back foot as continued selling pressure stemming from last weeks Public Spending Review work through the system.

The market is waiting to see if the Bank of England is seriously contemplating another round of QE and tomorrows GDP figure will probably give us a good indication of the Banks next move.

The forecast is for 0.4% on a quarterly basis but after the previous retail sales figure disappointed, we are bracing for a number showing a further weakening in growth.

A day of little action yesterday with money market’s attention being focused on the G20 meeting in South Korea. The Dollar did soften during the European trading day, but not on anything tangible – more on speculation of an impasse on the G20 discussions rather than fundamentals or economic news.

Sterling did not fare well however with continued concern over the UK economic outlook.

Buying the Greenback on an assumption that the G20 participants will be able to come to any agreement on currencies’ values or global economic rebalancing looks a very dangerous strategy and therefore I expect Euro/Dollar to ease back up into the high 1.39s before London’s close.

Remarks made by Tim Geithner, supporting a letter from the US delegation sent to the other nineteen G20 members, gave risk currencies a bit of a bid feel.

He said that G20 countries should cap their external imbalances at a particular, though unspecified, share of GDP.

It appears that the aim of any such measure would be to force export dependent economies to focus instead on stimulating domestic demand, and this should in theory reduce local objections to currency appreciation.

The US, however, are encountering strong opposition from other nations, specifically those in the Far East towards who, the accusative finger of the US Treasury tends to point.

Lack of progress at the G20 meeting will undoubtedly mean a continuation of Quantitative Easing driven markets and a longer term change of sentiment towards the Dollar would only emerge if/when US data begins to improve or it was deemed that the whole concept of QE was deemed ineffective.

As Wise Money expected the Bank of England’s release yesterday of the MPC minutes revealled that there was a three way split amongst it’s members.
Adam Posen showed that he argued for, and also voted for, an increase of £50 billion in the amount of QE in the system.

This kind of addition would equal a 25% increase in the holding of gilts by the BoE – a sizeable sum.

Naturally, the vote for no change outweighed Posen’s submission and also Andrew Sentence’s regular demand for a withdrawal of liquidity on perceived inflationary pressures.

Sterling didn’t react too well to the outcome – nothing serious but just looked a little vulnerable.

The Budget cut provided little additional information – lots of numbers and political jargon but nothing unexpected for the money markets to react to.

The more prevalent remarks came from the Institute of Fiscal Studies within a report released overnight.

In it they questioned whether the Government’s UK growth projections were overly optimistic and that there was a possibility that the £ 80 billion – odd of cuts might not prove to be enough.

Sterling reacted badly to this forecast, and fell to a 6-month low against the Euro.

Overseas investors are going to need verification that the behaviour taken would produce results before they get their assurance in the currency back. This will leave Sterling prone to continued downside pressure in the short term.

For global currencies, and ahead of this weekend’s G20 meeting in South Korea, two events have provide this morning’s interest. An interview with the US Treasury Secretary, Tim Geithner, reported in today’s Wall St Journal proved interesting reading.

He emphasised that the US had not embarked upon a policy of devaluing the US Dollar and that the strong dollar was still vital for global stability and recovery and that the major currencies values were roughly in line.

He did however divide countries into 3 groups and pointedly entitled the first, which included China, as those whose currencies were “undervalued by any measure”.

He berated the emerging market countries for not allowing market forces to set currency values (especially China) and stated that they all had a role to play.

He added that, “If China knew that if it moved more rapidly, other emerging markets would move with them, it would be easier for them to move.” This could all make G20 a bit lively with the US seemingly trying to create a them and us situation with the us being the ‘good guys’ and the them being cast as the villains.

As some of you may have noticed, money markets in general and the forex markets in particular love to have a dominant trading theme. Earlier in the year, eurozone sovereign debt and the (in)solvency of several nations hogged the headlines for months, the spotlight then moved to the general election in the UK and how Sterling was doomed if we had a hung parliament.

The US Dollar is currently smack bang in the eye of the hurricane and is looking at a third consecutive week of declines across  the board unless we get a major move this afternoon on the back of the release of a bucket load of US economic data including retail sales, CPI and the University of Michigan confidence figures.

As we all know, the prospect of another round of QE from the Fed is the reason for the Dollar’s sharp decline over the past few weeks and it is this move that is revealing the next theme that will dominate for the foreseeable future.

Currency intervention by every man (country) and his dog (central bank) seems to be on the cards, whether this takes the form of actual intervention in the market (Japan), not raising interest rates when you should (South Korea), slapping import tariffs on your competitor’s goods (possibly the US) or declaring that a rising currency means financial war (Brazil), we are currently entering unchartered waters in an environment in the FX markets last seen in the 1930’s.

With Ben Bernanke due to address Congress this afternoon, today may see light trading this morning before a volatile afternoon, if you have any Dollars to buy today it may be worth giving us call before lunch!

The Yen continues to gain against the Dollar as the game of chicken between traders and the Bank of Japan continues.

82 was the previous intervention level and we now trade at 81.21, overnight we saw more posturing by Japanese officials about direct intervention but no concrete action as of yet.

It is unlikely they will now intervene today, they usually choose the calmer Asian session for maximum impact, but it is worth monitoring closely for Yen buyers from both USD and GBP.

20 years ago today marked Britain’s first day as a full member of the ill fated European Exchange Rate Mechanism (ERM), aimed at reducing exchange rate variability and furthering monetary stability in Europe. The ERM was a first step on the road to a single European currency which we currently know as the Euro.

But as we all remember, the experiment did not end well.

Speculators including George Soros famously made a killing betting against the Pound and the downward pressure on Sterling first prompted interest rate hikes and finally Britain to formally pull out of the system.

The lesson the Bank of England learned that day was that no longer could a Central Bank hold back the tide (or should that be Tsunami) of the market.

Although we now live in a world of floating rather than fixed exchange rates, informal Dollar pegs by many developing nations are still used to manage exchange rates.

The sharp Dollar sell off over the past month leaves these nations in somewhat of a pickle. To maintain international competitiveness they must buy Dollars and sell their own currency to maintain the desired rate of exchange, but the whole market seems poised to short Dollars as soon as the Federal Reserve announces a resumption of quantitative easing.

Direct intervention may work in the short term (as witnessed by the spike in USDJPY after the intervention by the Japanese) but it is a futile and expensive policy if the market thinks otherwise.

The Dollar Yen pair is approaching levels once again when the Japanese may be forced to intervene and may do so over the weekend before European and American markets open, for maximum effect.

Both the ECB and BOE kept rates on hold yesterday at 0.5% with no changes to asset purchase schemes.

The latest GDP figures for the UK were released this morning showing a rise of 1.2% QoQ for the 2nd month in succession leading to a strong start for Sterling against its rivals. The leading indicator of economic health also illustrated an increase of 1.7% YoY painting the picture that the UK economy is steadying and looking at sluggish, but stable growth.

The news has kept the Pound above 1.58 against the Dollar, but also seen it bounce back over 1.18 in trading vs the Euro.

This has also been on the back of comments from the IMF and the Bank of England.

Firstly, the International Monetary Fund endorsed Chancellor George Osborne’s deficit reduction plans stating that the UK was “on the mend” and added the plan “greatly reduces the risk off a loss of confidence in public finances and supports a balanced recovery”.

Secondly, BoE Deputy Governor Charlie Bean said the central bank wanted households to “spend more rather than save”.

The Euro has taken a small hit this morning as Moody’s announced it was slashing the ratings of Anglo Irish’s debt, unnerving investors as Dublin tots up the final cost of rescuing the lender whose loans have crippled the Irish economy.

Government bond spreads between Germany and the struggling nations of Europe have widened again leading to more fears over the Eurozone debt situation.

Eurodollar is down a cent, which will bring relief to all exporters to the US as the pairing runs up against stronger resistance; it has been sitting on 5 month highs.

The Federal Reserve meeting yesterday evening did not throw up any surprises, but the Fed signalled a more sluggish outlook for the US economy and reiterated its willingness to take additional measures to boost the economy. There was no mention of concrete action as yet, which given the fact that we are rapidly approaching US mid-term elections, is sensible but the change in tone from “wait and see” to “we stand ready to act” was enough to reverse all of the Dollars recent gains in a broad sell off of the Greenback overnight.

Over the next few days we will see if the market is correctly pricing another bout of QE in the near term or if this move will be shrugged off quickly since central bank threats of action has been spectacularly unsuccessful over the past few months.

The Dollar sell off also brings the Japanese FX intervention back into focus, as the USD JPY pair moves back towards levels where intervention initially occurred.

Prime Minister Kan has been quoted as saying the intervention in the FX markets in not yet over, so the fear is fast becoming a beggar-thy-neighbour competitive devaluation as central banks scramble to keep exchange rates low in the hope of stimulating the faltering economic recovery.

The only problem is that not everyone can do it at the same time, and we can expect emerging markets and the commodity producing nations (since it will be these currencies that will strengthen as others devalue) to be none to happy about the prospect of significantly reduced competitiveness in world markets.

The Euro is benefiting from the USD weakness, although the Irish and Spanish bond auctions were broadly successful (the only issue was the high interest rate the market extracted for buying the Irish debt) it is Dollar weakness that is the main driver and we have moved past 1.33 in the EURUSD pair and under the 1.18 level in GBPEUR.

Over the past 10 years, the deliberate undervaluation of the Yuan by Chinese authorities has always been the elephant in the room in foreign exchange forex markets. The Chinese economic juggernaut has been powered by exports of manufactured goods to the west made cheap by very low input costs.

Quite rightly, China has been labelled the workshop of the world, and 8% average growth over the past thirty years has turned the underdeveloped middle kingdom to an economic powerhouse & the second largest economy in the world, behind the US.

America has long known China would overtake them eventually as the largest economy in the world, but they feel the Yuan undervaluation is giving the Chinese an unfair advantage.

The cheap currency encourages Chinese exports and promotes outsourcing of jobs from the US to China, which in a time of sluggish economic growth and stubbornly high unemployment in the US, automatically makes it political hot potato.

Treasury Secretary Tim Geithner’s comments yesterday that the US would use “all the tools we have” to reverse the bloated trade deficit with China, including WTO rules on fair trade, should come as no surprise in content, only in strength, given the usual soft tone used in diplomatic circles.

His comments come on the back of direct Japanese intervention earlier in the week aimed a curbing the strength on the Yen, and raises the prospect of a triangular trade dispute between the three largest economies in the world.

Sterling was, quite frankly, all over the place yesterday. Disappointing retail sales figures pushed the pound quickly lower in early trading, but as seems to be the way just now, we shook the negative news off quickly and resumed the march towards 1.57 against the USD.

Improvements in risk sentiment has aided Sterling’s move, as has improving economic data in Europe and the successful Spanish bond auction yesterday. The Euro has been driven higher against the Dollar, lifting Sterling versus the USD as well and we now trade over 1.31 in EURUSD and 1.57 in GBPUSD.