Decoding the Currency War Rhetoric Amid Unconventional Monetary Policy

Transcription

1 Decoding the Currency War Rhetoric Amid Unconventional Monetary Policy By Thomas D. Higgins, PhD Global Macro Strategist Federico Garcia Zamora Senior Portfolio Manager Currency Strategies Standish Mellon Asset Management Company LLC Accusations of currency manipulation were most recently leveled against the Bank of Japan after it committed to large-scale asset purchases and raised its inflation target prompting the yen to tumble sharply in early EXECUTIVE SUMMARY Standish Global Macro Strategist Tom Higgins and Currency Portfolio Manager Federico Garcia Zamora take a closer look at the current currency war rhetoric and compare today s situation with the currency devaluations of the 1930s. They argue against the idea that the primary intention of the unconventional monetary policies in most developed markets today is to weaken their currencies. However, they cite Japan and Switzerland as two developed countries who have used monetary policy to increase the competitiveness of their currencies. They also point to the absolute low level of interest rates and credit spreads to suggest that currencies offer an attractive means of enhancing returns in fixed income portfolios. Looking to central bank developments over the rest of the year, they say Standish favors the currencies of countries whose central banks have a neutral to tightening bias over those where central banks have a neutral to easing bias. We re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness. -- Brazilian Finance Minister Guido Mantega Mr. Mantega probably didn t envision thousands of press articles discussing currency wars when he coined the term in September He was simply voicing a concern shared by many of his counterparts in emerging markets that developed countries were intentionally weakening their currencies through unconventional monetary policies in order to gain a competitive edge. Accusations of currency manipulation were most recently leveled against the Bank of Japan after it committed to large-scale asset purchases and raised its inflation target prompting the yen to tumble sharply in early 2013.

2 Monetary Policy // 2 However, we do not believe that the primary intent of the unconventional monetary policies in most developed markets is to weaken domestic currencies. Rather, it is our view that these countries are seeking to lower interest rates in their local markets and ease domestic financial conditions in order to strengthen domestic demand. However, we do not believe that the primary intent of the unconventional monetary policies in most developed markets is to weaken domestic currencies. Rather, it is our view that these countries are seeking to lower interest rates in their local markets and ease domestic financial conditions in order to strengthen domestic demand. While a weaker currency may be a byproduct of these efforts in the short term, successful execution should actually be supportive of currency valuations in the medium term. In fact, it is worth noting that the real trade-weighted U.S. dollar is only marginally lower since the Federal Reserve implemented its first round of quantitative easing (QE) in late 2008 and broadly unchanged since it implemented the third round of QE back in September 2012, which may suggest the Fed s policies are beginning to gain traction. Exhibit 1 Federal Reserve U.S. Dollar Broad Real Trade-Weighted Index Index (March 1973 = 100) USD Feb-80 Feb-83 Feb-86 Feb-89 Feb-92 USTRBROA Index Feb-95 Feb-98 Feb-01 Lehman Shock Feb-04 Feb-07 Feb-10 Feb-13 Source: Standish using Bloomberg data from February 28, 1980 to February 28, As a fixed income manager, we are less concerned about the intent of central bankers and more interested in how our investors might benefit from their actions. Although currency volatility has generally declined over the past year, the absolute low level of interest rates and credit spreads suggests that currencies offer a more attractive means of enhancing returns in fixed income portfolios compared to other sources of alpha. The following discussion explores current currency war concerns and compares the present situation to that of the 1930s, when competitive devaluations were thought to have dominated the global landscape. We will then outline some of the themes we expect to play out in currency markets over the course of 2013.

3 Monetary Policy // 3 The 1930s Versus Today Episodes of competitive currency devaluations in which countries vie against one another to weaken their exchange rates and bolster exports have been rare. Instead, in the recent past, the pattern has been quite the opposite, with countries in Latin America and Asia aggressively fighting currency devaluation until international investors forced it upon them. This was certainly the case during the Latin American debt crisis of the early 1980s and the Asian financial crisis in the late 1990s. Devaluations tend to be viewed unfavorably because they are disruptive; the benefits in terms of increased competitiveness are often fleeting; and a weaker currency reduces the purchasing power of the local population. The period most commonly cited as the classic example of a currency war is the 1930s. At that time, the gold standard was the prevailing monetary regime, and most countries currencies were pegged to gold at a fixed exchange rate. Once the Great Depression struck, countries gradually abandoned the gold standard and allowed their currencies to devalue because it was the only means of expanding their domestic money supplies to combat deflation. 1 Had all countries responded in the same way and at the same time, the net effect would have been an expansion of the domestic money supply for each country with no effect on currency valuation. Unfortunately, misguided policymakers in some countries initially chose to maintain the gold standard and imposed capital controls and trade restrictions designed to switch demand to local producers. This strategy reduced the overall volume of global trade and slowed the global economic recovery. The period most commonly cited as the classic example of a currency war is the 1930s. At that time, the gold standard was the prevailing monetary regime, and most countries currencies were pegged to gold at a fixed exchange rate. The key difference between the 1930s and today is the nature of the shock. During the Great Depression, the deflationary shock was symmetric in that it affected all countries more or less equally. Today, the shock has been more asymmetric with developed markets (DM) being hit much harder than emerging market (EM) economies. 2 Economic growth remains disappointing in most DM economies and inflation rates remain subdued as they continue to deleverage. By contrast, economic growth rates are generally healthy in EM economies and inflation is somewhat elevated. Consequently, the aggressive monetary easing that central banks in DM economies are pursuing is not appropriate for EM economies. Moreover, EM countries are attracting capital flows from DM countries, which is putting unwanted upward pressure on their currencies; hence the claims from Mr. Mantega that the United States and other DM countries are engaging in a currency war. Federal Reserve Chairman Ben Bernanke has expressed little sympathy for this view. Mr. Bernanke has stressed that policymakers in some EM countries have chosen to resist currency appreciation as a means of promoting exports and domestic growth. He has pointed out that the perceived benefits of currency management come with costs, including reduced monetary independence and a susceptibility to imported inflation. 3 1 Ben S. Bernanke, Money, Gold, and the Depression, The Federal Reserve, March Barry Eichengreen, Currency War or International Policy Coordination, University of California Berkeley, January Ben S. Bernanke, U.S. Monetary Policy and International Implications, The Federal Reserve, October 2012.

4 Monetary Policy // 4 Switzerland and Japan have been more inclined to use monetary policy to increase the competitiveness of their exchange rates. Empirical evidence does not seem to support Mr. Mantega s claim either. Since it launched its first round of QE in late 2008, the Fed has expanded its balance sheet by more than 200% from roughly $900 billion to more than $3 trillion. 4 Likewise, the European Central Bank (ECB) has increased its balance sheet by 80% from $1.5 trillion to $2.7 trillion over the same period. Yet despite the rhetoric about how the Fed or the ECB may be using monetary policy as a stealth means of devaluing their currencies, the U.S. dollar has fallen only 5% and the euro 8% on a real trade-weighted basis since One might argue that economic fundamentals would justify even greater currency weakness, especially given the relatively strong economic performance of EM economies over that period. Exceptions to the Rule While a weaker currency may not be the primary goal of central bankers in most developed markets, there are exceptions to this rule. Specifically, Switzerland and Japan have been more inclined to use monetary policy to increase the competitiveness of their exchange rates. However, their situations are unique in that the Swiss and Japanese currencies were at extremely overvalued levels and both economies were mired in deflation. Indeed, based on purchasing power parity, the Swiss franc and the Japanese yen had been as much as 40% to 45% overvalued prior to central bank interventions. 5 Exhibit 2 Nominal Euro/Swiss Franc Exchange Rate (EUR/CHF) and OECD Purchasing Power Parity Index EUR/CHF Mar-90 Mar-92 Mar-94 Mar-96 PPP Mar-98 Mar-00 Mar-02 Nominal Exchange Rate Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Source: Standish using Bloomberg data from March 5, 1990 to March 5, 2013, and proprietary calculations for 20% deviation bands. 4 Federal Reserve H.4.1 Release, Factors Affecting Reserve Balances, February 21, Organization for Economic Cooperation and Development, Purchasing Power Parity Statistics, January 2013.

5 Monetary Policy // 5 Exhibit 3 Nominal U.S. Dollar/Yen (USD/JPY) Exchange Rate and OECD Purchasing Power Parity Index USD/JPY Mar-77 Mar-80 Mar-83 Mar-86 PPP Mar-89 Mar-92 Mar-95 Nominal Exchange Rate Mar-98 Mar-01 Mar-04 Mar-07 Mar-10 Mar-13 Source: Standish using Bloomberg data from March 5, 1977 to March 5, 2013, and proprietary calculations for 20% deviation bands. The Swiss intervention was explicitly aimed at the exchange rate. In September 2011, the Swiss National Bank said it was setting an exchange rate floor of 1.20 Swiss francs/euro. At the time, the franc was seen as a safe haven from the European sovereign debt crisis and demand for franc-denominated assets was so strong that nominal short-term Swiss interest rates became negative. The Swiss National Bank said that the value of the franc was a threat to the economy and responded with a promise to buy foreign currency in unlimited quantities to enforce the floor. 6 The franc immediately fell 9% against the euro and nearly 10% against the dollar on the day of the announcement. 7 The Japanese yen has tumbled approximately 20% against both the U.S. dollar and the euro between October 2012 and March Unlike the Swiss, the Japanese didn t establish a ceiling or intervene directly in the foreign exchange market to depreciate the yen. Newly elected Prime Minister Shinzo Abe stepped up pressure on the Bank of Japan (BoJ) to stimulate economic activity and end the deflation that has plagued his country for the better part of the last decade. To this end, the BoJ raised its inflation target to 2% and stepped up the size of its asset purchase plan. Still not satisfied, Mr. Abe appointed a new central bank governor, Mr. Haruhiko Kuroda, who is known to be more open to unconventional policies than his predecessor. The Japanese yen has tumbled approximately 20% against both the U.S. dollar and the euro between October 2012 and March Swiss National Bank Policy Statement, September 6, Bloomberg, March 4, Ibid.

6 Monetary Policy // 6 We believe that the best way to take advantage of opportunities in the foreign exchange markets today is to keep a close eye on central banks. Opportunities in Foreign Exchange We believe that the best way to take advantage of opportunities in the foreign exchange markets today is to keep a close eye on central banks. Whether it is their intention or not, easier monetary policy tends to weigh on currency valuations in the short term. At present the Bank of Japan s shift toward a more aggressive easing stance coupled with the Swiss National Bank s ceiling in the value of the Swiss franc has increased the relative attractiveness of the U.S. dollar as a safe-haven currency. We believe the euro will continue to be a tactical play as the European debt crisis remains an ongoing concern. In general, within the major currencies we prefer the U.S. dollar and euro over the Japanese yen and Swiss franc. Elsewhere, it is our view that the currencies of Scandinavia and the dollar bloc countries: New Zealand, Australia, and Canada, will continue to benefit from high commodity prices, relatively higher domestic interest rates, and a better fiscal profile compared with other developed markets. Meanwhile, we expect emerging market currencies to be driven by idiosyncratic factors. For those EM economies that depend on foreign direct investment and portfolio inflows to finance current account deficits, caution may be warranted, particularly in an environment of dollar strength.

7 [THIS PAGE INTENTIONALLY LEFT BLANK]

8 BNY Mellon Investment Management is one of the world s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon s affiliated investment management firms, wealth management services and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. The statements and opinions expressed in this document are those of the authors as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon, BNY Mellon Asset Management International or any of their respective affiliates. This document is of general nature, does not constitute legal, tax, accounting or other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon Asset Management International Limited and its affiliates are not responsible for any subsequent investment advice given based on the information supplied. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested. While the information in this document is not intended to be investment advice, it may be deemed a financial promotion in non-u.s. jurisdictions. Accordingly, where this document is used or distributed in any non-u.s. jurisdiction, the information provided is for use by professional and wholesale investors only and not for onward distribution to, or to be relied upon by, retail investors. Products or services described in this document are provided by BNY Mellon, its subsidiaries, affiliates or related companies and may be provided in various countries by one or more of these companies where authorized and regulated as required within each jurisdiction. This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value. This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management International Limited. The Alcentra Group BNY Mellon ARX BNY Mellon Cash Investment Strategies BNY Mellon Western Fund Management Company Limited The Boston Company Asset Management, LLC The Dreyfus Corporation EACM Advisors LLC Hamon Investment Group Insight Investment Mellon Capital Management Corporation Meriten Investment Management The Newton Group Siguler Guff & Company LP Standish Mellon Asset Management Company LLC Urdang Capital Management, Inc. Urdang Securities Management, Inc. Walter Scott & Partners Limited In Australia, this document is issued by BNY Mellon Asset Management Australia Limited (ABN , AFS License No ) located at Level 6, 7 Macquarie Place, Sydney, NSW Authorized and regulated by the Australian Securities & Investments Commission. In Brazil, this document is issued by BNY Mellon Serviços Financeiros DTVM S.A., Av. Presidente Wilson, 231, 11th floor, Rio de Janeiro, RJ, Brazil, CEP BNY Mellon Serviços Financeiros DTVM S.A. is a Financial Institution, duly authorized by the Brazilian Central Bank to provide securities distribution and by the Brazilian Securities and Exchange Commission (CVM) to provide securities portfolio managing services under Declaratory Act No , issued on December 19, Investment vehicles may be offered and sold in Canada through BNY Mellon Asset Management Canada Ltd., a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager. In Dubai, United Arab Emirates, this document is issued by the Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. If this document is used or distributed in Hong Kong, it is issued by BNY Mellon Asset Management Hong Kong Limited, whose business address is Suites , Level 12, Three Pacific Place, 1 Queen s Road East, Hong Kong. BNY Mellon Asset Management Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission and its registered office is at 6th floor, Alexandra House, 18 Chater Road, Central, Hong Kong. In Japan, this document is issued by BNY Mellon Asset Management Japan Limited, Marunouchi Trust Tower Main Building, Marunouchi Chiyoda-ku, Tokyo , Japan. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. In Korea, this document is issued by BNY Mellon AM Korea Limited for presentation to professional investors. BNY Mellon AM Korea Limited, 29F One IFC, 10 Gukegeumyung-ro, Yeongdeungpo-gu, Seoul, , Korea. Regulated by the Financial Supervisory Service. In Singapore, this document is issued by The Bank of New York Mellon, Singapore Branch for presentation to professional investors. The Bank of New York Mellon, Singapore Branch, One Temasek Avenue, #02-01 Millenia Tower, Singapore Regulated by the Monetary Authority of Singapore. In Singapore, this document is to be distributed to Institutional Investors (as defined in the Securities and Futures Act, Chapter 289 of Singapore) only. This document is issued in the UK and in mainland Europe, by BNY Mellon Asset Management International Limited, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No Authorized and regulated by the Financial Services Authority. This document is issued in the United States by BNY Mellon Investment Management. BNY Mellon owns over 95% of the parent holding company of The Alcentra Group, which is comprised of the following affiliated investment advisers: Alcentra, Ltd and Alcentra NY, LLC. BNY Mellon ARX is the brand used to describe the Brazilian investment capabilities of BNY Mellon ARX Investimentos Ltda. BNY Mellon Western FMC, Insight Investment and Meriten Investment Management do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms services or funds to any U.S. investor, or where otherwise unlawful. BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People s Republic of China. BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. BNY Mellon owns a 19.9% minority interest in The Hamon Investment Group Pte Limited, the parent company of Blackfriars Asset Management Limited ( Blackfriars ), Hamon Asset Management Limited and Hamon Asian Advisors Limited ( HAAL ). Only Blackfriars and HAAL offer investment services in the U.S. Services offered in the US, Canada and Australia by Pareto Investment Management Limited under the Insight Pareto brand. The Newton Group ( Newton ) is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC). BNY Mellon Asset Management International Limited and any other BNY Mellon entity mentioned above are all ultimately owned by BNY Mellon, unless otherwise noted The Bank of New York Mellon Corporation. 3/13 bnymellonim.com BNY Mellon Investment Management