September 18 (King World News) - Along with volatility in stocks and historically low yields in bonds, investor attention has recently been drawn to currencies. This is due to the currency wars that broke out in 2010 and have expanded lately. The recent Brazilian decision to cut interests rates to halt the appreciation of the real and the Swiss decision to peg the franc to the euro are both examples of countries cheapening their currencies against others, or at least halting their appreciation. The world is now in a beggar-thy-neighbor phase, last seen in the 1970’s and before that the 1930’s, where countries steal economic growth from neighbors by currency depreciation to cheapen exports.
Switzerland and Brazil are mere sideshows in this global war. The main event is the three-ring circus of the U.S., Europe and China and their respective currencies, the dollar, euro and the yuan. The dynamic is straightforward – all three would like a cheaper currency, relative to the others, to help exports. China has the least justification for cheapening, so it considers a peg the next best thing – at least their currency doesn’t go up. The U.S. has the most clout – it has the leading reserve currency and a printing press so it can just print its way to devaluation. Europe desperately wants to depreciate but is dependent on China to buy its sovereign bonds and dependent on the U.S. for dollar liquidity in the form of swap lines so it has no leverage over the other two. Besides, Germany has a history of maintaining a strong export sector even with a strong currency because of its efficiency, homogenous culture and labor-management cooperation. This was true in the 1970’s with the strong Deutschemark and it’s largely true today. This dynamic plays out as you might expect. The U.S. devalues against yuan and the euro – it gets all of what it wants. China revalues upward against the dollar, but keeps a peg to the euro – it gets half of what it wants. And the euro remains strong against the dollar and pegged against yuan – so it gets none of what it wants. This has been the prevailing paradigm since June when the Chinese finally let the yuan appreciate against the dollar in a serious way.
There’s only one problem with this neat solution to the currency wars. Germany may be able to survive with a strong currency but the rest of Europe cannot and parts of Europe, especially Greece, are facing insolvency. Up to a point, the Greeks have to accept the fiscal austerity forced on them by the Germans. But beyond a certain point, either the Greeks or the Germans balk, and the crisis goes critical and threatens the stability of the global financial system. At that point, either the euro must weaken significantly or Germany must rescue Greece. German reluctance on the bailout has recently led to a weaker euro as a default or break-up loomed. However, this euro weakening broke the global arrangement with China, which was now faced precisely with its worst case – a weaker euro and a weaker dollar at the same time. China is prepared to accept one or the other but not both.
So it goes in the currency wars where all advantage is temporary and it is always just a matter of time before the strong currency tries to get in on the debasement game that everyone else is playing. Since not everyone can devalue at once, every “winner” with a cheaper currency must produce a “loser” who gets stuck with the strong currency. At first it looked like Europe was the biggest loser but now China is beginning to assume that role. China will not tolerate it and has laid down two markers. It has told Europe that if they expect China to purchase European sovereign bonds to help alleviate the crisis, they must offer more favorable trading terms to China. And there is an implicit threat that if the euro does not strengthen soon, China could re-peg to the dollar, thus undoing what the U.S. had hoped to accomplish with its weak dollar policy.
The entire global system is at a critical juncture with sovereign bonds, currencies, stock markets and the fate of politicians all in play. The hidden purpose of QE and QE2 was always to cheapen the dollar by causing inflation in China and forcing its hand. Critics have said that QE did nothing to help with unemployment and consumption. But that was never the main purpose – the purpose was to weaken the dollar to help exports and get jobs that way, but it takes time. I removed QE3 from my set of expectations late in 2010 when it became clear that Fed rollovers were enough to keep the yield curve tame and, more importantly, China was finally starting to move on the currency. For now, QE3 is still off the table. But if the euro weakens and China re-pegs to the dollar as a result, that is the signal for more QE. It’s hard to know how this will play out, but at least we know what to look for. If you want to see QE3 ahead of the market, watch the euro.
Finally, it is not quite true there are no winners in a currency war. There is always one winner – gold.
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