Currency Wars, Revisited

Whenever people start talking about “currency wars”, it’s never a good thing.  And the longer they go on, the more destructive they can be.  Currency wars refer to a process whereby numerous countries simultaneously attempt to gain trade advantages through the devaluation of their currencies.  The problem is, though, that when many different countries are devaluing their currencies at the same time, it is hard to determine which countries, if any at all, will ultimately benefit.  For this reason, currencies wars have frequently been described as “a race to the bottom.”  Rather than one clear winner, it is more often the case that all will suffer some economic damage as a consequence of widespread and simultaneous currency devaluation.

The effects of the gathering currency storm can be seen in South Korea’s trade figures for August, which were reported Tuesday morning.  South Korea’s exports fell 14.7% year-over-year in August while its imports were down 18.3% year-over-year.  These are very large declines which, for political reasons, are unlikely to be met with inaction.  Rather, the South Korean government is likely to join in the “race to the bottom” in an effort to boost exports, and therefore jobs and economic growth, from depressed levels.  And as South Korea (and others) devalues, the Chinese are likely to respond in kind and continue the vicious cycle.  It is hard to predict the ultimate ramifications of this gamesmanship, which is why investors hate currency wars.

The ongoing currency wars are one reason that we think the Fed will either defer interest-rate hikes until next year or make one small, symbolic raise and then pause.  Why?  Because the mere anticipation of Fed interest rate hikes caused the dollar to surge as much as 25% against a basket of foreign currencies from mid-2014 through March, 2015.  During the course of the dollar’s appreciation, US exports stagnated while cheaper imports created disinflationary pressures in the US.  The double-whammy of lower exports and lower-than-expected inflation puts the Fed in a bind.  Should Yellen go ahead with the initial rate hike in an effort to maintain credibility, or will she kowtow to the data and defer the first hike?  It’s a very difficult call.

The Fed must also consider the ramifications of its actions on the global economy, particularly within the more-volatile emerging markets.  Leaders in emerging-market countries have been lobbying the Fed to stand pat for now rather than begin the tightening process.  These governments are concerned that the dollar’s continued strength will cause further capital flight and higher inflation rates, which could both lead to sharply higher borrowing costs and lower economic growth.  In addition, the rapid increase in dollar-denominated debt by emerging-market entities in recent years would become much harder to service if the dollar were to appreciate further.  On the other hand, emerging-market countries would stand to benefit from higher exports if the dollar were to appreciate against their respective currencies.  You guessed it – more uncertainty.

What is more certain is that if the Fed does go through with the first rate hike, the dollar will rise further and create an additional pressure on exports.  Lower exports would be a drag on both job creation and economic growth.  Effectively, the US would be subsidizing the economies of the rest of the world.  This is not necessarily a bad thing for the long-term health of the global economy, but the short-term political ramifications in an election year are hard to predict.

As for their effect on the capital markets, currency wars are an anathema.  Currency devaluation can be a rational response to a slowing economy or to the problem of too much sovereign debt.  Indeed, if Greece had the ability to devalue its currency, it would not be in the predicament it is in now.  However, when everyone resorts to currency devaluation at the same time and currency wars ensue, the economic outcomes can be highly unpredictable.  And the markets hate uncertainty.  We need only look at the action in the bond market over the past few weeks to show that the writing was on the wall.  Rather than rates moving higher, as nearly everyone expected heading into a Fed tightening phase, the yield on the 10-year Treasury note has dropped rather precipitously from its near-term high in June to about 2.16% today.  And, as is so often the case, the bond market was far quicker than the stock market in determining there were clouds on the horizon.

If you’re a little confused, that’s kind of the point.  Mass confusion is not the backdrop for healthy capital markets.  That, we’re completely sure about.