Currency markets contend with a devaluation dilemma
March 11, 2015
The U.S. dollar Catch-22 feedback loopU.S. dollar Catch-22 feedback loopU.S. dollar Catch-22 feedback loop is in full swing, with the deflationary effects of a strong dollar being felt globally. We identified this theme early on, and from the beginning we thought that it would be unlikely for the dollar to rally without (1) causing carnage in the commodities space, (2) prompting further currency wars, and (3) creating a general downdraft on inflation globally. This view has been accurate; in fact, we probably haven’t been bearish enough on how fast markets would recognize the difficulties a strong dollar might create.
The problem now is that these devaluations are implicitly creating the next round of devaluations. This is extremely dangerous in our opinion, because the Catch-22 has turned into a devaluation dilemma as every major central bank attempts to import inflation while exporting deflation.
The faces of a devaluation cycle
Simply put, today’s devaluation trend is driven by central banks, which are reacting to lower inflation readings and diminishing growth by devaluing their respective currencies. In a classic reflexive dynamic, central banks are essentially adding fuel to the fire, creating the next move downward in deflation.
As explored in our December commentaryDecember commentaryDecember commentary, the sequence goes something like this:
- The U.S. dollar strengthens, putting a downdraft on commodities.
- Global inflation drops like a stone on the slide in commodities.
- An initial group of central banks react, thinking they need to devalue their currencies in order to capture inflation and export deflation.
- Additional central banks join the fray by also weakening their currencies to remain competitive and to maintain exports.
This interpretation of the feedback loop has served us well, but how will the Catch-22 play out from here? We envision a sort of uncomfortable reflexivity in central bank decisions, which could lead us down a potentially dangerous path.
A reflexive market can be hazardous
When boiled down to its simplest terms, reflexivity is the idea that market participants influence each other (and therefore markets) in self-reinforcing ways. Thus, when one bank devalues its currency, it prompts other central banks to do the same. Central banks thereby create a reactionary environment that further exacerbates existing biases. These cycles, if left unchecked, have the potential to turn into an outright currency war, the implications of which could be enormous for the global economy and securities markets. Potential ramifications include:
- Deeper global deflation
- A rise in the value of dollar liabilities globally, bringing about major credit implications for corporations exposed to such liabilities (estimated at $9 trillion as of 2014, according to analysis published by the Bank for International Settlements)
- Declining dollar revenues from sales abroad, putting further pressure on earnings
- Higher volatility in currency markets (with the potential to filter into other asset markets)
- Less foreign direct investment, due to concerns about investments being instantly devalued
- Rampant and aggressive protectionism
- Outright collapse of intervention regimes
- Collapse of fiat currencies en masse
One doesn’t have to look too far into the past to see the potential consequences of aggressively manipulating currency values. We witnessed the first casualty of the currency war earlier this year, when the Swiss National Bank (SNB)Swiss National Bank (SNB)Swiss National Bank (SNB) scrapped the Swiss franc’s ceiling against the euro after possibly receiving word from the European Central Bank that quantitative easing (QE) was indeed going forward. In letting go of its currency ceiling, the SNB acknowledged that the QE program was essentially a tidal wave coming its way, one that could force it to buy large amounts of euros in order to maintain the franc’s ceiling. This forced the bank to act pragmatically in abandoning the ceiling.
Shockwaves are still being felt from the SNB’s decision, which provided two lessons:
- currency interventions don’t work, and
- it’s dangerous to keep a currency artificially cheap.
These are lessons that global markets would not enjoy experiencing on a larger scale (say, if similar actions were undertaken by national banks in China or Japan). Nonetheless, signs of reflexive currency devaluation remain.
Where there’s smoke...
In our opinion, if a currency war were to play out, we think the first harbingers of doom would be currency devaluations by Asian finished-goods producers. We would expect Korea and China to be the most likely to head down this path. We believe such a scenario would look something like this:
Is there a smoother path?
The sequence above describes a series of events that could potentially happen in the coming years; but there are a few potential restraints that could freeze the currency war and pause the reflexive devaluation dilemma:
- A strong dollar causes U.S. growth to recouple with the globe, slowing the U.S. while other economies speed up.
- Global growth and inflation tick upward, with regions trending more closely together, thereby closing Pandora’s deflation box.
- The dollar sells off because the Fed backs away from hikes or signals that it isn’t hiking again until it sees signs of inflation.
- Supply/demand technicals cause the dollar to fall for the time being, causing a lift in commodities.
- Commodities skyrocket due to some unforeseen geopolitical issue (Ukraine? Russia? Full-scale war against ISIS?), injecting inflation back into the system.
- Countries are successful at “capturing” inflation and we end up with unexpected pockets of inflation globally.
Our views on probable outcomes
Although we suspect that the U.S. economy is unlikely to decouple from the rest of the world, this might actually be good news because it might dampen the dollar’s strength. Our base-case scenario is that the U.S. economy will slow down along with the rest of the world, causing currencies’ devaluation trends to take a temporary breather against the dollar. This might cause the Fed to recognize the dangers of dollar appreciation and back away from anything more than a few finely tuned rate hikes. This might slow deflation in the U.S., but it will once again put pressure on Japanese and European inflation via their currencies.
The obvious problem in this scenario is that without real growth across the global economy, this would only be a temporary pause in the currency devaluation war we find ourselves in. Despite this modestly hopeful near-term dynamic, we continue to see dollar strength over the medium term, which will continue to place deflationary pressure on the globe and reinforce the devaluation dilemma.
In our best-case (albeit unlikely) scenario, robust economic growth could return along with inflation. This might prevent central banks from chasing other central banks down the reflexive-currency-war rabbit hole. (If growth and inflation pick up, central banks will be unlikely to attempt any further easing)
Finally, while we don’t see near-term evidence that we are headed into a global managed-single-currency regime (as some analysts are fearing), our worst-case scenario is that there is some probability that it may happen. Two potential firebreaks for this rather apocalyptic scenario are that as inflation globally converges at zero and economic growth sputters, the need for individualized currency moves will become less necessary. However, we think it would only take a few cautionary Swiss-type implosions for markets to recognize that a currency war is not something any single country can win and that “winning” the battle often means losing the war.
Read other comments from our investment teams on China and currencies:
The views expressed represent the Manager's assessment of the market environment as of February 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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