Eurozone joins Japan’s ‘currency war’ versus the US dollar

US$ Index Jan15aThe last 10 days have seen turmoil in major currency markets:

  • The Swiss National Bank gave up trying to devalue versus the euro, and the franc jumped 30% in minutes
  • The European Central Bank (ECB) launched its €1tn Quantitative Easing (QE) programme, causing an immediate 3% fall in the euro’s value versus the dollar

These are major moves by any historical standard, and highlight how earlier ‘currency wars’ have broadened in scale.

Their origin was in 2009, when the US Federal Reserve launched its first QE programme.  One of its key impacts (whether intentional or otherwise) was to devalue the US$ – thereby supporting export growth and the US economy.  By 2011, after the Fed’s QE2 programme, the US$ Index was down 19% as the chart shows.

But then the Bank of Japan launched its own QE programme.  And in October last year, when the US$ Index seemed likely to fall again, it launched its QE2 programme.  Last Thursday, the ECB began its own QE programme, effectively joining the war on Japan’s side.

Japan and Europe have ageing populations and so cannot generate domestic growth.  By weakening the currency, the ECB and Bank of Japan expect to compensate for this by generating growth in export markets.  In turn, however, these competitive devaluations create major risks for the global economy, as the greatest central banker of modern times, Paul Volcker, has explained:

Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. I think it gets dangerous when they lose sight of the basic function of the central bank.  The key issue concerns what this “function” should be. The basic function of a central bank is to defend the value of the currency,” he insists, as his highly successful experience in the 1980staught him how limited a central banker’s powers really are”.

CHINA HAS ABANDONED STIMULUS FOR A ‘NEW NORMAL’ APPROACH
The problem is that currency wars are a zero-sum game.  Today, Japan and the Eurozone are winning at the expense of the USA and Switzerland.   Thus the US$ Index has broken out of a 30-year downtrend, and is at an 11-year high. 

Effectively, though, this means that 2 of the world’s 4 largest economies are effectively waging a currency war against the largest economy, the USA, as well as against Switzerland.  This cannot end well.

Within a few weeks, the Fed will find that the US recovery is suddenly weakening again:

  • The collapse of the shale gas/oil bubble means US jobs growth will soon reverse, and housing starts slow
  • US companies will lose market share in export markets as Japan and Europe become more competitive
  • The rise in the value of the US$ will also help to ensure that the US slips into deflation.
  • And so the Cycle of Deflation will likely move forward another stage, towards protectionism and tariffs

Of course, there is another way forward, which avoids this zero-sum game.

China’s new leadership realised 2 years ago that its previous policies had been a complete mistake.  It has since adopted ‘New Normal’ policies, based on an acceptance that ageing populations inevitably lead to lower economic growth.  As Zhou Xiaochuan, governor of the People’s Bank of China, told the World Economic Forum in Davos last week:

If China’s economy slows down a bit, but meanwhile is more sustainable for the medium and long-term, I think that’s good news”

Unfortunately, very few of his peers seem to be listening to his common sense message.

WEEKLY MARKET ROUND-UP
The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:

Benzene Europe, down 57%. “Current market fundamentals do not support any significant upturn on benzene pricing”
Brent crude oil, down 53%
Naphtha Europe, down 53%. “Buying appetite in downstream petrochemical markets is thin as polyethylene players wait for the February ethylene contract to settle”
PTA China, down 44%. ”Buyers were mostly purchasing on a need-to basis, adding that the market outlook remains uncertain”
¥:$, down 15%
HDPE US export, down 23%. “Most domestic export prices continued to slip on lower ethylene and energy market values”
S&P 500 stock market index, up 5%

IMF says economic growth may never return to pre-crisis levels

UnwindingThe Great Unwinding of policymakers’ failed stimulus programmes is now clearly underway in the global economy.  The headlines this week all focused on the latest International Monetary Fund (IMF) report:

IMF says economic growth may never return to pre-crisis levels.”

And then, in response, the US Federal Reserve suddenly realised that the US economy was not as strong as it had hoped.  As the Wall Street Journal headlined yesterday:

Federal Reserve officials have become more concerned that weak overseas growth and a strengthening U.S. dollar will crimp the domestic economy and hold down inflation, an outlook that has made them more inclined to stick to low interest rates.”

This confirms the blog’s suggestion back in August, when it highlighted the start of the Great Unwinding:

Recent speeches by the new Fed Chairman, Janet Yellen, have been equivocal at best, suggesting she is not clear about the best policy to adopt.  There is also the fact that to some extent, events are moving out of central bank control”

Market action in the US Dow Jones Industrials Index confirms the volatility that is now developing:

  • The Dow fell 1.4% on 1 October, before jumping 1.2% last Friday
  •  It then fell 1.6% on Tuesday this week, before jumping 1.6% on Wednesday
  • Yesterday it fell 2%, leaving it down 3.6% since its peak at the time of the Alibaba float last month

Meanwhile Brent oil has fallen $24/bbl since its late June peak.  And no, that isn’t a typo.  Brent traded at $114/bbl between June 19 – June 23, and closed last night at $90/bbl.  The US$ has been equally volatile:

  • Against the Japanese yen it has risen from $1 : ¥101 in early August, to $1: ¥108 last night
  • Against the euro it has risen from $1 : €0.71 in early May, to $1 :€0.79 last night

These are enormous moves in such as short space of time, and will be extremely destabilising for the global economy.  Very soon, no doubt, the IMF will have to revise down its estimate for global growth for a 4th time this year.

THE OUTLOOK REMAINS VERY SCARY
The reason for this drama goes back to the legacy of the failed stimulus policies seen since 2008.  They created a tidal wave of liquidity which destroyed the ability of markets to undertake their key role of price discovery:

  • Markets completely lost touch with the reality of supply/demand as a result of this liquidity
  • But now, supply and demand balances are starting to matter greatly as the stimulus policies come to an end.

The blog developed its original analysis of the Great Unwinding in 5 posts during August – September.  Very clearly the risks that it then identified are now coming true.

In response to many requests, it has now combined these posts into a special Research Note.  Please click here to download a copy.  And do please feel free to circulate it to your colleagues and business partners for discussion.

Next week, the blog will also launch ‘The pH Report’.  It aims to help companies and investors survive the Great Unwinding of central bank and government stimulus now underway.