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The Fuel of a Currency War, Part 2

The Fuel of a Currency War, Part 2

Article Summary: In an effort to prevent another Financial Collapse, the world’s largest Central Bank has taken on massive intervention efforts in an effort to stimulate their economies. This environment has been dubbed ‘The Global Currency War.’ In our last article, we looked at what happens to an economy when a currency increases in value. In this article, we look at why an economy might want to look in the other direction.

In our last article, we examined how a currency increasing in value can add massive complication to an economy.

For an economy that exports heavily, a rising currency can make those exported goods more expensive in foreign countries. As those goods become more expensive in foreign countries, consumers in those economies may look to make different purchasing decisions for lesser-priced, yet similar goods. The decrease in sales seen due to these higher prices can ravage an economy; much like what has been seen in Japan for the past 20+ years. We previously took a more granular look at such situations in the article, How a Currency Can Change the World.

As you can imagine, few would welcome such a situation. A company can make better products more efficiently, and yet still face turbulence simply because its nation’s currency is increasing in value. Many great companies face tough situations, and a form of helplessness can begin to seep in because regardless of what that company does, the increasing value of a currency can make export operations increasingly more difficult.

Why ‘Weak’ is the New ‘Strong’

This has led to a widespread posture of attempting to invigorate the other side of that coin: Nations artificially weakening their own currencies in an effort to make their goods cheaper overseas. The hope is that sales of exports can increase enough to begin providing growth for the economy, which, eventually – can lead to an increase in interest rates and a much healthier economy.

One needs only to look at the recent performance out of Japan to see how these effects can work together. Since the results of Japanese elections became more imminent with Shinzo Abe re-taking the office of Prime Minister in Japan, a campaign that was ran on the premise of economic reform; markets have displayed the ideal reaction to a currency-weakening regime. This has become known as a 2-part relationship, dubbed the ‘Abe Trade.’

The first part of the ‘Abe Trade,’ is a continually weakening Japanese Yen. The below chart is EURJPY, illustrating the sharp increase in price seen in the pair since traders began factoring in the ‘Abe Trade,’ (and since ¥ is the counter-currency in the pair, this would amount to ¥-weakness, and €-strength.)

Created by J. Stanley

Meanwhile, we’ve seen the Nikkei increasing in value so quickly that we’ve broken 4+ year highs, with prices not seen since the index was in the process of melting down during the Financial Collapse.

Created by J. Stanley

So this relationship has been one of logic: As the Yen weakened in value, it made it easier for foreigners to buy their goods. The additional sales of those goods are driving stock prices higher as Japanese companies can begin to look to outperform their previous estimates. So far, the ‘Abe Trade’ has proven successful for the Japanese economy.

Sounds pretty good doesn’t it? As a matter of fact, it sounds so good – that it might be something that any and every economy would want to do whenever tough times were faced. This is where the situation gets sticky.

The Birth of a Currency War

The World found itself in a difficult spot in 2008, and in the years since. The housing bubble in the United States spilled over across the globe, and sparked an even more contentious situation in Europe that, still-to-this-day, remains not only unresolved but not even close to the modifications in structure that many economists feel will be necessary for the longer-term success of the Euro Zone (primarily speaking about an element of unification so that such situations can be properly addressed when/if they rear their ugly heads in the future).

Coming out of the Financial Collapse, the United States embarked on the first round of Quantitative Easing. This is the action of printing dollars to buy bonds. These are new dollars, created out of thin air without any additional value attached. This has the technical function of devaluing a currency because it’s simply printing more without any additional value being created.

The corresponding move should, and did, work to add considerable devaluation to the US Dollar.

Created by J. Stanley

The first round of QE did quite a bit to keep the economy from melting down further in 2008, but unfortunately did not provide the exact turning point in regards to unemployment, and economic growth that many had hoped. So the United States embarked on another round of Quantitative Easing, dubbed ‘QE 2.’ This was even more devaluation to the US Dollar, and currencies such as the Euro, the Aussie, the Kiwi, and even the Yen increased in value against the greenback.

Just like we looked at in our last article, that increase in valuation only served to add more pressure to these economies as the world attempted to hobble out of the Financial Collapse. As you can imagine, these economies did not appreciate the fact that an already difficult environment became even more challenging, and this is where the ‘Currency War’ gets its start.

The United States was devaluing US Dollars, this added pressure to Japanese exporters – so Japanese Central Bankers made moves to weaken the Yen. Two of the largest national economies in the world embarked on a race, attempting to weaken their currency more than their neighbor across the Pacific.

But the Currency Wars do not end there, as other economies want to retain their competitive footing in light of the devaluation policies being embarked upon by their larger neighbors. China employs a ‘fixed-floating-rate’ regime in which the Yuan is loosely tied to the US Dollar. So as those US Dollars get artificially weaker due to policy, so does the Yuan. This action can provide support for Chinese markets, which, in turn, can add support for markets out of Australia or New Zealand, where strong trading relationships can carry strong correlations with China.

Europe is in a more precarious situation, as they don’t yet have the mandate to embark on such an action of printing new Euros. This highlights the fact that structural reform must be made for long-term viability of the single economy. There are 27 nations governed by a single over-arching monetary policy in which little flexibility is available to counter such actions from competing governments and economies.

Moreover, Europe finds itself in the unenviable position of seeing a rising currency in an environment in which much of their economy continues to face headwinds. Unemployment is over 25% in Spain, and for those under the age of 25 that number has been seen as high as 60% unemployment. Unemployment is over 11% in Italy, the 10th largest national economy in the world and a nation that appears very close to re-electing a politician that has already been convicted of Fraud. Perhaps more troubling, Berlusconi promised to repeal the reforms in Italy that have largely allowed the nation to avoid economic catastrophe under Mr. Mario Monti.

The risk of such action can be catastrophic, yet the Euro continues to ascend to new highs against currencies such as the US Dollar and the Japanese Yen.

This is a Currency War; and it’s not just starting, it’s already begun. The stakes have just increased as Japan is now heavily in the continuous currency-devaluation fray and the higher the value of the Euro, or the further it seems that they’ve moved beyond the economic crisis, the more the stakes increase.

In our next article, we’ll look at potential outcomes while focusing on the more prominent or probable scenarios to see how we can build a game plan to trade in such a unique and interesting environment.

--- Written by James Stanley

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.