Forex trading – Currency wars are much talked about but what exactly is meant by the term and how does it affect traders?

Whether you call it by the more benign ‘competitive devaluation’ or not, the issue at stake is the same – national governments, usually via their central banks, acting to weaken their currencies to boost their economies.

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Currency Wars

 

In a world of fiat, or floating, currencies, devaluation of a currency is achieved by central banks by means of their monetary policy. The ‘looser’ the policy, the more a currency should depreciate - in theory.

Lowering interest rates or quantitative easing are two common methods to loosen monetary policy.

Since the financial crisis, dozens of nations have embarked on super-loose monetary policy experiments to stimulate their economies - hence why people talk about a race to the bottom and currency wars.

Currency wars are often seen as a zero-sum game – a beggar-they-neighbour exercise where no one ultimately wins.

The Combatants

 

On the front line are the central banks of the world’s largest economies.

The Federal Reserve drove interest rates to almost zero and launched three separate QE programmes designed to stimulate demand. The Fed is now one of the first to tighten rates and has stopped buying debt; the effect of which has been to spur the dollar higher against its peers. A softening in language from the Fed in 2016 has seen a cooling in dollar demand.

Japan’s central bank is arguably the most aggressive, buying up practically every government bond in existence and now hoovering up equities as well. A weaker yen is the aim for Japan’s heavily export-led economy but an experiment with negative rates has produced a stronger currency – evidence of the complexity of currency wars in practice.

The European Central Bank held fire for the longest but is now a full combatant. QE was launched and later expanded, while rates are now in negative territory. Mario Draghi is refusing to full rule out ‘helicopter money’ – the nuclear option in the war. Whatever it takes.

China has been repeatedly attacked by the US for maintaining an artificially weak currency and is currently on the Treasury Department’s list of potential currency manipulators – along with Japan, Taiwan, Korea and Germany.

Concerns about China’s currency are increasingly important to wider financial markets, as evidenced by the turmoil in August and January.

A Fragile Truce

 

Markets are awash with rumours that the big players have agreed some kind of truce in the long-running skirmishes.

A G20 meeting in Shanghai in February may have seen some cooperation, but it’s not another Plaza Accord (when, in 1985, the governments of France, Japan, West Germany, the UK and the US agreed to weaken the US dollar by intervening in currency markets).

The rally in the dollar, which begun in June 2014 and lasted until the end of 2015, had unnerved many and may have led to some kind of action by central banks to stop talking down their currencies.

Certainly the turmoil in markets from the dollar-renminbi relationship is not something policymakers desire – better coordination on policy is likely to help soothe markets.

If the guns have been silenced for a time, it’s not because there is total harmony. The ECB may have simply given up on trying to engineer the euro lower, while the rise in the yen post NIRP is another sign that central banks are finding it increasingly hard to manipulate markets.

The truce may simply be a sign that they’re out of ammo. The ECB and Bank of Japan may be waiting for the Fed to act – patience is the name of the game as the US central bank reins in its rate hike ambitions this year. That’s perhaps why Draghi and Kuroda are so keen to stress that policy action takes time to produce the desired effect.

However, the Reserve Bank of Australia’s recent salvo – cutting rates to a record low at its meeting in May – is a sign that this is a conflict that is ready to reignite at any moment.