Currency wars are coming. Will the U.S. Federal Reserve’s interest rate moves make it worse?
- By Edward HarrisonEdward Harrison is the founder of the Credit Writedowns and a former career diplomat and investment banker. Follow him on Twitter: @edwardnh.
On January 15, the Swiss National Bank (SNB) abruptly decided to end its policy of intervening in the foreign exchange market to hold the euro exchange rate with the Swiss franc (CHF) above 1.20 Swiss francs to the euro.
All hell broke loose. At one point, the Swiss franc climbed by nearly 40 percent against euro, ending the day almost 20 percent higher, at near parity with the common currency.
As the dust settles, the casualties are mounting. Retail currency broker Alpari U.K. filed for bankruptcy early Friday because its customers sustained so many losses after the Swiss franc appreciation. Currency brokerage FXCM may not be able to stay in business as its clients “experienced significant losses”. FXCM Chief Executive Officer Drew Niv explained in a statement that clients had “generated negative equity balances owed to FXCM of approximately $225 million.”
We have never been here before.
To put the Swiss franc move in perspective, in the currency cross rates for free-floating major foreign exchange currencies — like the Swiss franc or the U.S. dollar, the euro or the British pound sterling — a 2 or 3 percent move would be considered big. A 20 percent move is outlandish, a freak black swan event without precedent.
This violent correction, a consequence of the Swiss National Bank’s policy of essentially pegging the Swiss franc to the euro, is a harbinger of more volatility to come. Welcome to the currency wars.
So how did we find ourselves in this reality? Earlier in the month, I examined this question from the perspective of the emerging markets, which have grown tremendously in economic importance. The emerging markets are in turmoil now because of a strong dollar, with the crisis in Russia a precursor to volatility that could strike elsewhere. Overall, however, the currency wars are an outgrowth of a shrinking pie mentality — where economic policy is driven by a grab for market share.
In the wake of the financial crisis that began in 2007, policymakers worldwide are painfully aware of their individual declining growth prospects. You don’t get elected to office when growth is slow and unemployment is high. So politicians have done anything and everything they could to prop up their sagging economies, including actively engaging in policies designed to depreciate their currencies and “steal” growth from abroad.
The Swiss franc, traditionally a safe-haven currency to which investors flee when times are tough, rose some 30 percent against the euro over the course of the the European sovereign debt crisis early this decade. This was a huge blow to near-term growth in Switzerland, a small, open economy dependent on trade, as it made Swiss exports much more expensive. The Swiss intervened in the market, buying up massive amounts of foreign currency in order to depreciate the value of the Swiss franc. But these actions were not enough to move the franc down to level that gave comfort to Switzerland’s powerful export community. So the Swiss National Bank decided to act. In September 2011, the SNB told the world, “it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20.” That meant, in effect, that the Swiss franc was pegged to the euro at an exchange rate of 1.20 francs to the euro, with the SNB committed to intervention to maintain that level.
There were costs, though. The SNB’s balance sheet is one of them. As the currency wars raged, central banks around the world eased monetary policy. The European Central Bank has been no exception. Recently, rates were cut to zero by the ECB, which controls monetary policy for 19 members of the eurozone, a subset of the 28-member European Union. In fact, the ECB has gone so far as to tax banks 0.25 percent for holding excess deposits at the central bank, effectively a negative interest rate. And these policies have caused the euro to wilt in foreign exchange markets, putting pressure on the Swiss National Bank to intervene in currency markets in order to maintain the 1.20 floor.
The result is that the SNB’s balance sheet is now about 500 billion francs, which is 80 percent of gross domestic product. To put this in perspective, 80 percent of GDP is a level three times larger than the balance sheet size of the U.S. Federal Reserve or the Bank of England relative to the size of their respective economies. It is enormous. Only the Bank of Japan has been more aggressive.
Apparently, this expansion has become too much for the SNB to bear politically. The Swiss pride themselves on sound monetary policy — and a balance sheet of this size due to currency intervention just isn’t the quintessential hallmark of sound money. Thus, the Swiss gave up the ghost. They dropped the peg and let the currency float. Instead, the Swiss National Bank will now raise the tax it will charge banks to deposit excess money, to 0.75 percent from 0.25 percent. The SNB also said it would move its target for 3-month Libor to the range between -1.25 percent and -0.25 percent, from the current range between -0.75 percent and 0.25 percent. Both moves are measures to deter hot money from putting upward pressure on the Swiss currency.
So what are the takeaways here?
First, it highlights how much the world has changed. A strong currency is not a bad thing. The Swiss franc, the Japanese yen, and the German deutsche mark all appreciated against the U.S. dollar for years in the 1970s and 1980s and their economies remained strong. In fact, these economies had some of the best growth rates in the developed world. A strong currency is a good thing because it means you have to give up less in productive capacity for the goods and services you buy from abroad. But in a world in which domestic demand growth is weak and growth globally is also weak, countries don’t want a strong currency for the simple reason that it means short-term pain as exports become less competitive in the shrinking pie of the global economy.
Second, politics are always going to be central to how economic policy gets made. In a perfect world, a central bank could have a balance sheet that is equivalent to 100 percent or even 200 percent the size of its currency area’s GDP — if it felt this were warranted. It could even take mark-to-market losses on those assets that made them temporarily worth less than its liabilities. But we don’t live in that world. Central banks are political entities which exist at the behest of government. And as such, they will always need to be mindful of politics if they are to maintain political favor and to keep their independence.
Third, I think the turmoil from the Swiss franc move puts huge pressure on the U.S. Federal Reserve to reverse course and not tighten policy any further by raising rates. The move in the Swiss franc should be seen as casualty of a strong dollar, just as oil and commodities have been, in part. Fed Chair Janet Yellen has said that she cares how Fed policy affects other economies and global economic conditions. A 20 percent move in a major global currency in one day that is blamed on policy divergence by the central bank behind that currency has to figure into the Fed’s calculus. Consider the Swiss franc move a major phase shift in the currency wars, then.
Fourth, if the Fed does go ahead and raise interest rates in the United States in June as I have been expecting, the dollar will remain strong and more turmoil will come. Expect oil, commodities, and emerging market currencies to drop and for those economies and for asset markets in those economies to come under pressure.
Fifth, 12-month U.S. Treasuries are now yielding less than 0.15 percent. Irrespective of whether this is a safe-haven bid, 0.15 percent is a figure which is well under 0.25 percent, where the Fed would have to move if it raised rates. Moreover, the 2-year Treasury is trading at 0.43 percent, under 0.50 percent, meaning hiking twice would put the policy rate above the present two-year rate.
That means that a Fed that hiked interest rates could invert the U.S. yield curve. Long-term rates could be lower than short-term interest rates. As Ben Bernanke, the former Fed chair explained in 2006 when concern about the last U.S. recession began, an inverted yield curve can be interpreted a sign of impending recession. And here one could argue that an inversion would be the result of Fed policy. Bernanke poo-pooed those concerns in 2006. But, it now turns out, recession did come just as the yield curve was predicting.
Let’s be clear. The currency wars are a bad thing, not a good thing. Now, in a perfect world, the easy monetary policy of a currency war could be like a coordinated devaluation. But in the real world, it’s not. Central banks move unilaterally, due to their own narrow political and economic exigencies. Time and again, we have seen unilateral moves by major central banks, whether it be the Fed’s quantitative easing (QE) that set off talk of the currency wars in 2010, the Swiss 2011 currency floor move, the Bank of Japan’s 2013 quantitative easing move to support Abenomics or the European Central Banks’s own impending QE. And these unilateral moves have costs. Look at the unwinding of yesterday’s Swiss move and you see this.
These are dangerous times. The world is addicted to monetary stimulus. And central banks are doing their best to meet that addiction with the monetary-stimulus drug that traders and speculators want. But, this policy response, while understandable, means monetary policy is in an abnormal state. And this has created serious macro imbalances. Now, as the U.S. Federal Reserve normalizes policy, those imbalances spell trouble for emerging market and global asset markets. The Swiss franc move is just the scary canary.
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