To say these are unprecedented times is an understatement. Global Central Banks are using every single monetary policy tool at their disposal to try and fight the forces of deflation and this has resulted in currency wars. In fact, 15 central banks have eased monetary policy in one way or another this year. Since this is a global economy each move made has far reaching affects upon all nations and their abilities to control the imbalances being caused by central bank brute force.
The term currency war gained prominence in 2010 when Guido Mantega, Brazil’s Finance Minister, complained that quantitative easing (QE) was weakening the US Dollar and prompting other countries to respond so they wouldn’t lose their export competiveness. This led to a “race to the bottom” in which all countries were engaged in trying to weaken their own currencies as much and as quickly as possible. Fast forward to today, as the chart below shows, and the opposite situation holds true. The USD has strengthened dramatically since 2011 and is sitting at decade highs. The biggest part of the move has come since the summer of 2014.
What is interesting though is that since the USD bottomed in 2011, all other currencies - as well as most other commodities - spiked. Below is a chart of the Australian Dollar which illustrates this perfectly, as it peaked out in 2011 and has been dropping ever since. The Australian Dollar is known as a risk on trade because it is tied heavily to commodities and China. The inverse relationship between the USD and commodities, along with China’s growth slowing, has hurt. In an effort to stimulate the economy, the Reserve Bank of Australia (RBA), Australia’s central bank, cut interest rates for the first time in 18 months. All the way to the right on the chart, you can see the Australian Dollar move lower as a result of this move.
The Canadian Dollar has had a similar move as well, and topped in 2011. Canada is heavily tied to the energy sector, as it is one of the largest energy producers in the world. Canada also had an emergency rate cut a few weeks back.
The state of affairs of Europe and Japan have been talked about ad nauseum, and makes it needless to say that they are both trying to stave off deflation while stimulating growth in their respective economies. The European Central Bank (ECB) and the Bank of Japan (BOJ) are both actively engaged in QE. Below are the charts of both the Euro and the Yen.
Europe, Japan, and Australia are examples of countries using currency devaluation as a monetary policy tool to stimulate growth. With interest rates in the developed world at near zero, or even in some cases negative, this makes borrowing costs for the corporate sector almost nothing. It is also causing asset prices to rise since savers are being punished and are moving into riskier asset classes in search of higher yield. Monetary stimulus allows central banks to export deflation to other parts of the world. The Danish Kroner is pegged to the Euro and as a result has had to cut interest rates 3 times in the last 2 weeks due to a falling Euro, caused by the announcement of QE. This relationship is probably doomed to failure. The Swiss National Bank (SNB) learned its lesson the hard way and had to de-peg as it was becoming too costly with the sinking Euro to maintain the peg and continue buying Euros. The move has hurt the Euro and caused ripples all over the world as it was unanticipated by global markets. Below is a chart of the Swiss Franc. The peg started in September 2011 and ended in January. This is an extraordinary move in currency.
China has also joined the party and cut interest rates but it may have a bigger problem which is the loose peg it has to the USD currently, when the USD is surging and China is trying to loosen monetary policy. The trade weighted exchange rate has jumped 10% since July. This is having a negative impact on the profit margins of Chinese domestic companies, and caused issue with tightening monetary policy. Deflationary forces are at China’s doorstep, and this may mean the yuan will need to devalue, and quite possibly de-peg.
All of these moves by central banks have caused huge amounts of volatility in the Foreign Exchange (FX) market. This is problematic because higher FX volatility makes hedging more expensive for companies and discourages foreign direct investment. Essentially, it causes countries to focus internally and hurts global growth, which we are starting to see happen.
Being that the US has ended QE (for now) and indicated it will raise interest rates at some point this year, coupled with what is perceived to be a strong domestic economy, the USD has strengthened and investment has flowed to the US. As has been written before in The Drumbeat of Deflation, the USD and commodities have had a negative correlation, where as the USD goes up, commodities go down, and vice versa. Commodities are down dramatically since 2011, where they peaked and they continue to fall, which is very deflationary. Below are 2 charts of commodity prices. One of them is from 2011 until now, and the other the last 365 days. With the exception of gold, the fall in most commodities has been precipitous.
This should not be happening in a global economic recovery. What is even more perplexing is the yield on the 10 year bond. It has been falling and is near record lows. The bond market does not believe the recovery story and is worried about deflation as capital flows have moved into bondsand the USD. These are NOT signs of recovery. Below is chart of the 10 year bond yield:
The 30 Year yield is at a record low:
The world has been in a deflationary state since 2001, and the cause of this deflation has been the bursting stock market bubbles (Asian Crisis of 1997, Dotcom 2000, Great Recession 2008, and now possibly the currency wars). This has all led to competitive devaluations through central bank tools to try and stimulate respective economies, which has led to more deflation in a vicious cycle that has become a negative feedback loop. Deflation creates a loss of pricing power, a downward trend in prices, an erosion of profits, and an excess capacity, particularly in developing countries with low cost factories and huge new labor forces. What does this mean? There is a demand problem! Developed markets have embarked on QE (particularly the US, Japan, and Europe) has led to significant capital inflows into emerging economies (Brazil, Russia, India, China, and South Africa, commonly known as BRICS), particularly China. This liquidity came at a time when governments were involved in internal growth projects to stimulate domestic demand. This led to a boost in the demand of commodities, and possibly capital goods. This demand however was not real and was caused mainly by global misallocations of capital and speculation, as investors were looking for excess returns. This led to excess capacity and that is why commodity prices have been crushed by this house of cards. All the excess liquidity caused commodity prices to rise without real global demand for them, and now we are witnessing the fall out caused by deflationary forces at time when the USD is strengthening and global debt levels are at record highs.
This has led to a world of deep imbalances among different countries and different sectors of the global economy. Each country has its own inflation and monetary histories, along with boom and bust cycles. As a result, each country has formed “beggar thy neighbor” policies acting out of self-interest, and this has manifested itself in the form of trade and capital flow imbalances between countries.
Aside from liquidity, the world is awash in irresponsible monetary policy with unknown and certainly unintended consequences. If you are confused by what this all means, you are not alone. Fiat currencies have gone wild, and it is time for the people of world to be protected from the actions of a select few who pretend to have an idea of the future. Financial freedom is a right all people should enjoy. Former CEO of UBS and Credit Suisse Oswald Gruebel has openly voiced his support for Bitcoin and distrust of fiat currency. It looks like he is onto something.