Negative rates and the currency wars
It may be better to think of the outbreak of negative interest rates as simply another weapon in an ongoing and global low-grade currency war.
It’s not that negative interest rates – under which investors pay for the privilege of lending money – are not driven partly by terrible growth prospects and a rising threat of deflation.
They are, but they are also the manifestation of monetary policy that says, in essence, to global investors: “don’t let the door hit you on the way out.”
That’s because a central bank which is desperately looking for growth – and that means just about all of them – would like nothing more than to see its currency depreciate.
The European Central Bank is the latest to light the negative interest rate fuse, cutting key rates last week by 25bp to 0.75%. This gave rise to what has to be the 8th wonder of the financial crisis – the spectacle of France raising short-term money at negative interest rates. Germany and the Netherlands are also able to sell debt at negative yields, while Danish banks will end up owing their central bank hundreds of millions annually after their central bank cut a certificate of deposit rate to – 0.20%.
While the primary intended impact of this kind of monetary policy may be to force money from the sidelines into riskier investments, all central banks will understand that some of that money will travel outside their currency zone and that this too, by making their exports more competitive, will have a stimulative effect.
A great, concrete example of this in action is the shuttering of euro-denominated money market accounts by JP Morgan, Goldman Sachs and BlackRock to new investments in the wake of the ECB’s move. While this surely will push some would-be investors into riskier investments within the eurozone, many will also choose to take their money elsewhere.
The Swiss National Bank has been fighting a hot war against currency strength, maintaining a very expensive and risky policy of capping its franc against the euro. This obliges it to buy euros for francs when the exchange rate approaches its 1.20 line in the sand, and has helped take its foreign currency reserves to US$376bn, an increase of more than US$60bn in June alone. As Michael Derks, currency strategist at brokerage FxPro points out, much of that cash is likely being reallocated by the Swiss out of euros and into other currencies, thereby putting upward pressure on currencies like the dollar and yen.
From currency war to trade war
Interestingly, Brazil, which mounted strong efforts against hot inflows of money, has recently relented, in June partly scrapping a tax on foreign loans after a strong fall in the value of its real. While this might seem as if it denotes a falling chance of stronger currency tensions, the real’s tumble was driven in large part by the dawning realisation by investors that Brazil will not be immune from global weakening. It may well be that Brazil won’t be the special target of speculators looking to get out of euros or yen, but the Bank of Japan and ECB still have as much incentive to encourage them as they ever did.
The same dynamic that makes cheapening your currency attractive also leads to disputes on trade policy. This is especially true in a US presidential election year.
It should come as no surprise then that the US last week launched a complaint at the World Trade Organization alleging China has imposed unfair duties on more than US$3bn in exports of US-made automobiles. This comes even as the yuan approaches its 2012 lows against the dollar, driven down by a deteriorating outlook for Chinese growth.
Look for a steady stream of this sort of thing as we approach November, and while China may well keep its head down, every trade complaint, and they will not be limited to the US and China, carries with it the chance that one party or another will retaliate in currency markets, or by some form of capital control.
Too little, too slow
None of this is to say that the ECB was not right in cutting rates. If anything their action was too little, and many months tardy. The euro will likely depreciate from here, either because official policy guides it lower or because policy is botched and it lurches lower.
This is exactly why we should expect more currency conflict, and with rising stakes. With China showing signs of deflation and European in recession, the Federal Reserve will be next to act.
Whatever the Fed does, one of the intended effects will be to weaken the dollar, sending the ball right back to the ECB.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)