Tag Archives: Exchange Rates

The Relentless Rise of the Dollar and Fall of the Yuan

With sentiment at the Fed shifting toward a rate rise in June, and news today in the Wall Street Journal (see China loses resolve to revamp Yuan) that China is again worried about the pressure on the Yuan, we can all predict what is about to happen. 

The low interest rate the Fed promotes has been described as a response by the Fed to the lack of active policy by the US government to drive economic growth. The market distortion as a result of the low interest rate are frightening. There was a piece, albeit an opinion, in yesterday’s Financial Tines that explained the impact on savings (negative), retirement planning (disastrous), and debt (growing toward all time highs again).   But we will not change the government’s actions overnight, not until November that is, and even that is not guaranteed. So we are stuck between a rock and a hard place. The Fed wants to raise rates but has to avoid chocking off the meager growth that is limping along.

China has its own economic challenges. As it wrestles with the gradual transition from a manufacturing based economy to a consumer and services based economy, it is using the exchange rate to control its export competitiveness. Note that in recent times, in studying the UK’s transition between late 1950’s to the 1990’s, this effort won’t be easy or quick. But China is trying to move quickly, perhaps too quickly.  And despite the IMF signaling it’s faith that China was going to let the market drive the Yuan’s exchange rate, the People’s Bank of China (PBOC) continues to take action to stabilize its currency. 

Assuming the Fed increase interest rates in June, we will all hear that big sucking sound again as capital flies from emerging markets including China back to American shores and the powering dollar. This will trigger a fall in the Yuan and the PBOC will again start to leverage its foreign exchange reserve to stem the losses. That reserve has fallen from an estimated $4th to about $3.2tn in the last year or so. The question is, how far can that reserve go in defending the Yuan?

Sterling was ‘broken’ in the 1970’s and the U.K. Government had to go to the IMF for a loan – check out “Decline to Fall: The Making of British Macro-Economic Policy and the 1976 IMF Crisis, Douglas Wass, 2008”.  That was a low point for the UK. The pound was again ‘broken’, perhaps more famously, by George Soros during ‘black Friday’ when the UK was forced to leave the Exchange Rate Mechanism (ERM), a pegged exchange-rate system that preceded the single currency, the euro. 

Clearly the PBOC won’t use up all its reserves. So the question becomes: what is the level at which the market expects massive red flags? Perhaps a leading indicator to watch are the monthly reported FX outflows from the PBOC. As that ramps up, the red flags will start to fly. And they won’t be the party flags of choice- they will be the economic panic flags that none of us want to see.

The Peculiar Thing about Currencies and Bonds

As every day passes by our central banks and currency czars head further and further into uncharted territory. What is going on now could not have been predicted, and the resulting behavior cannot be anticipated. Worse, there are no lights at the end of the tunnel, just ever growing darkness.
This weekends newspaper headlines highlight the nightmarish situation:

Japan’s nightmare roots are well known, starting with record breaking public sector debt, which continues defy logic but has yet to become an active challenge. This makes Japan different to other sovereign states but the other roots are common across other nations as follows.

The Bank of Japan (BoJ), like many other central banks, has a never-seen-before burgeoning balance sheet as a result of Quantitative Easing (QE), a process whereby central banks purchase debt and therefore drop billions of dollars (or local currency) from the sky. This policy helps lower interest rates and thus, so the theory goes, encourages private sector investment and so economic growth (e.g. GDP). This has not happened. The ghoulish result is that:

  • Firms did not increase capital spending 
  • But instead took out low cost bonds to fund massive and ongoing share buy-backs and unproductive or natural-cycle meters and acquisitions.

The result is that the investor class has gotten richer and inequality has gotten worse. As the data published by central statistical agencies around the world report the depressing news, corrosion in trust by the public in the political system increase now to the point where national elections are being fought more on distrust with government than with positive policy comparison.

QE encourages the exchange markets to disinvest in the local currency, thus lowering the exchange rate. This should then, so the theory goes, encourage exports. However this has not happened either. The monstrous condition now is that other large, mature, trading nations are in the same boat and all are engaged in the same QE effort. So all markets are flooded with cash, and the trillions of dollars that slosh around in the currency exchange have no clear direction where to call home. In fact, as one nation lowers its rates, in the hope encouraging some increased exports, other nations have reacted with additional QE this neutralizing any advantage sought. The result is a rush-to-the-bottom where we continuously lower rates without any resulting benefits. And bottom we are approaching with zero, even negative rates. At some point banks will have to pas such rates onto households.

As the article about Japan reports, the BoJ must be considering new action at some point, but political considerations will likely figure strongly due to the pending US election. More crucially when everyone is in the same sinking boat, one would think that coordination, nay, collaboration might be the order of the day. And when I mean collaboration, I am thinking along the lines of Bretton Woods or Plaza Accord. We cannot get out of these woods, or prevent the boat from taking on more water, with the current beggar-thy-neighbor approach. 

The other side of this nightmare is just as confounding.  

German yields, the return for holding a bond of government debt over a long period of time, is approaching zero. It could well go negative very soon. Japanese yields went negative earlier this year and US yields are very close to zero too. If you take into account (meager) inflation, real US yields are already negative.

Note that the Federal Reserve holds about 20% of outstanding government bonds (i.e. debt); the Bank of England holds about 26% of the U.K. Government gilts (i.e. debt); and the Bank of Japan holds about 30% of their government debt, as of March. The ECB holds about 10% of outstanding German government debt. So the market is hugely distorted, and private buyers are crowded out. 

But the complication does not stop there. In the interests of QE, the ECB is now expanding beyond government debt into corporate bonds, which crowds out even more the private sector. This changes the dynamics for how forms seek long term capital investment. Investors (see WSJ ECB’s Debt Purchases Cause Concern) are now worried that should private bind holders sell any amount of debt, the price will swing violently due to the loss of liquidity as a result from central banks owning large swathes of the market and not being active in it.

The perverse logic of negative rates means that there is no incentive for investing in the debt. More staggeringly we are slowly learning that we can only just guarantee the return of the capital ‘stored’ in those bonds. And the assumption is that the cash when returned the will be worth less than it is now. But as demand increases for this unproductive asset we have to assume that this is the best of a bad bunch of investment options. What does that say about our confidence in waking up and getting out of this situation?

But do our economic and financial leaders work together to find a global solution? No they do not. They seem happy to assume our problems are not at a global level but can be handled one decision, one policy, one central bank at a time. They have signally failed to solve this problem alone and in tandem. They need to work in parallel and that requires real collaboration, the kind not seen since Bretton Woods and the Plaza Accord.  I have been talking about this need for global collaboration for some time – see my last missive, Preserving our Future Wealth for Future Generations, and my earliest from 2015 Open Letter to Christine Laguarde, head of IMF.

This is an inside down financial world and there are literally no signs of getting out of it. The one hope, the one glimmer of an way out, is if inflation does take root. That once enemy incarnate is now needed to save our economy before our leaders ruin it. They show now signs of taking a global leadership role. So we pin our hopes on inflation. And by the way, if inflation ever did take hold, that won’t be pretty either. Remember the central bank’s balance sheet and amount of QE ‘out there’ in the market? That would have to be sucked out pronto and yields would alike immediately and rates would raise dramatically. We are set for a nightmare that will just go on, and go on.

On a Knife Edge: US Interest Rates and the Saving of the Global Economy

I like Greg Ip – a journalist who writes for the Wall Street Journal. I read his column whenever I have the newspaper in hand and his views and understanding of the economy seems to align quite well with mine, most of the time. But this morning I read his piece in the US print edition of the Wall Street Journal, called As Dollar Falls, Global Economy Perks Up (Thanks, Fed).

The article states factually, and shows graphically, how a rising dollar (a phenomena since early 2014) has, for the most part, been a hindrance to the world economy. As the Fed signaled hints of its first rate rise, it’s “lift-off” resulted in a great sucking sound from emerging markets as capital changed direction from high risk markets to the save haven of the US. If interest rates were to rise, better be there on the ground to attract the (slightly) juicer returns. And when we say capital, we are talking of billions of dollars a day in deregulated capital flows. This harmed local currencies, reduced confidence, and generally has been a pain for those emerging markets.  

Once the US interest rate “lift-off” actually started, and the Fed announced an expectation that rates would rise steadily through the year (2016), the strength of the dollar increased and the capital flows toward the US notched up in 2015. Trouble was brewing global as the US economy seemed to be doing quite well when the rest of the world was looking a bit pesky. This, to me, looked like Yellen’s Roosevelt Moment, in reference to the time in 1933 when Roosevelt basically stuck two fingers up at the global economy, torpedoed the World Economic Conference, and took the dollar out of what had been until then, an agreed exchange rate structure.  Any attempt at cooperation to save the global economy was gone.  The US walked off the stage.

What is most interesting since that first rate rise is that Yellen passed the Roosevelt test. The “lift-off” has been much less of a “take-off” and more of a “hold”. Rates have not raised any more, and so the dollar’s rise in value has halted, indeed, it has started to fall. As such capital is again flowing back to towards emerging markets and so stability in the exchange rate and capital flow patterns has begun to emerge. But here is the conundrum that is building: The US economy is certainly not creasing, it is showing fleeting signs of improvement. Should inflation show any hint of an increase, as commodity price falls drop out of the inflation calculation, all talk will again turn to the continued “take-off” as in “vertical movement. That will then reverse capital flows once again, and very sharply. Once inflation kicks in, the Fed will have a devil of a time coping with its pressures due to the unreal level of quantitative easing it has dropped onto the economy. So while Yellen may have passed her initial and most important Roosevelt Moment, she has quite a few similar moments ahead. And we are not playing here with just the US economy – we are playing with the whole shootin’ match!

The Ghost of Keynes Haunts Our Global Leaders and Economic Conditions Today

I would like to ask you an honest question – but the title of this blog will have given you the answer already.  Who do you think the author of the following text is?

We have reached the conclusion that there is no means of raising world prices except by an increase of loan-expenditure throughout the world.  There are, I think, three, and only three, possible lines along which we can lend assistance.

  1. The first, and perhaps the most obvious, means is that of direct foreign loans, in the style to which we have been accustomed in the past, from the strong financial countries, which have a favorable foreign balance or excessive reserves of gold, to the weaker, debtor countries.
  2. The second, and more promising, means is for the stronger financial countries to increase loan-expenditure at home.
  3. Yet, once again, it seems obvious that we are discussing, so far, remedies of which the quantitative effect is hopelessly disproportionate to the problem of raising world prices. I see no reliable prospect of a sufficient rise in world prices within a reasonable time, except as the result of substantial, and more or less simultaneous, relief of taxation and increase of loan-expenditure in many different countries. We should address great important to the simultaneity of the movement towards increased expenditure. For the pressure on its foreign balance, which each country fears as the result of increasing its own load-expenditure, will cancel out if other countries are pursuing the same policy at the same time. Isolated action may be imprudent.  

You are correct to conclude that this is none other than John Maynard Keynes.  And to be honest, I have to admit that I have not changed any text whatsoever but I did remove a few extra words and/or lines that provided additional context but do not detract from the base message.  So now the second question – when was this written?  Many of you will know that Keyenes died a young man – he left us only just a short while after the adoption of the Bretton Woods Agreement (1944).  The passage above refers to “gold” too – which is a bit of a give-away, surely.  To help you gauge from when this narrative was plucked, here is another related comment from the same paper:

We all agree that the settlement of war debts and of reparations are, first of all, indispensable. For these are of primary importance in creating fear of acute tension in the foreign exchanges.

Here the reference is to war debts.  That is a give-away, right?  This refers to, of course, the war debts and reparations owed between the Allied and Central powers at the conclusion of the Great War.  I will put you out of your misery – the text above is taken from The Means to Prosperity, published March 1933, as four articles in The Times.  

What I find most fascinating about this passage is the fact that, baring the reference to gold, this problem, and the solution, are very similar to what we face today.  The passage above, when read completely, refers to advice Keynes is giving regarding pending World Economic Conference due to take place later in 1933.  And what is most interesting item about this is that in the run up to this famous conference, the major economic powers of the world – including the US – were in agreement about the need for stable exchange rates over stable prices.  What made this conference famous was not the agreement, but that newly elected President Roosevelt famously “torpedoed” the conference before it concluded by announcing, unexpectedly that the US was leaving the fixedly exchange model and going to devalue the dollar, to initiate the New Deal.  

What is hard to get one’s head around is this: The US effectively told the world to ‘go away’ and survive on your own.  But in so doing, the very size, homogenous nature, and unique balance of domestic demand versus global trade, resulted in the US, some years later, helping the world as a whole.  The one, minor downside to all of this was that as the US walked away from global leader and economic monitor, the decision left Europe off the hook and any reigns that might have slowed the rise of economic Germany and its new deal were dashed.   

Moving beyond the politically incorrect conclusions this might bring, let’s look at what Keyne was saying in 1933.  His comments are no less true then as they are now:

  • We have a beggar-thy-neighbor policy by each nation in terms of currency exchange and domestic interest rates
  • We have each central bank suggesting that others need to do more for each other, as they each do more for their own economy
  • We have no global agreement or coordinated effort

We need a new World Economuc Conference.  Perhaps it should take place in New York, or perhaps Bejing.  We need to align interest rate raises together, at the same time.  We need to coordinate infrastructure investment; we need to coordinate tax reduction and regulatory simplification to help spur new business growth.  We have to do this altogether.  As it stands today, we have no hope, and Bob Hope, and he left the building.

And if you think Keynes is too outdated?  Check out one of his last comments in the third article: “Thus what is to the advantage of each of us regarded as a solitary individual is to the disadvantage of each of us regarded as members of a community.”  He was righ then – he is right now.

The Emerging Market Alarm Bells are Ringing

A short article in the US print edition of the Financial Times Weekend publication warrants careful attention. It does not trigger an immediate change in behavior but it does suggest something I have already predicted, that may warrant a change soon. Firstly, the article is called, “Dollar Strengthens as EM Exodus Gathers Pace“, by Roger Blitz and Jennifer Hughes. The point drawn is that even though the markets had a fraught time last week, the dollar quietly strengthened as investors continued to turn away from emerging markets and toward apparent strength in the US economy.
This is having the affect of lowering EM currency values compared to the dollar, and increasing the dollar value against other currencies. This imports to the US become less expensive (worsening the US trade deficit) and exports become more expensive. But trade with the world is not as significant percentage of the American economy as with some other large economies, I hear you chide. Yes, that is true, but the point is emerging markets and other countries, and firms, price many or much of their debts and loans in dollars, since it has attracted seriously low rates and is a reliable currency. As more money flows toward the dollar, the value goes up compared to other currencies, and the amount of sell local currencies one has to sell in order to buy dollars to repay that debt, goes up.

The article explores the Chinese efforts to control its “free” currency. Of course it is devaluing, carefully, against the dollar. But the market is stronger, and more trigger-happy. The People’s Bank of China (PBOC) has changed the way it values the renminbi against the dollar in order to soften any direct change in value with the dollar by using a broader basket of currencies. It is entered the market several times recently and sold vast amounts of its dollar exchange reserve to help slow the fall of its currency against the dollar. The efforts are many, the impact are adequate, so far. But the market is something you struggle to fight against and you hope you never have to.  

Then you have to add in the fact that the US Federal reserve diverged from the rest of the central banks around the world with a rate rise, albeit small, in December. This is what is triggering the dollar rise – apparent faith in a stronger US economy. But as the market is so volatile, small changes lead to big impacts. As the imbalance between EMs and the US continues, the Fed may in fact be motivated to reverse direction to send again converge with the EBC, Bank of Japan, and the U.K. and revert back to more easing by reversing its interest rate rise. Not solely due to currency challenges but to the impact of those currency impacts on global trade and the entire economic system.

I love the phrase quoted toward the end of the article. “Investors were used to the Fed getting ‘intimidated by the whiff of grapeshot’, said Steven Englander, FX strategist at Citigroup. But the US economy might be resilient enough to sidestep deteriorating financial market conditions.” If not, the Fed may yet lower interest rates before they raise them again.

China’s Quantitative Tightening In Focus

On August 10th I blogged (see The Coming Yuan and the Falling Dollar) about a recent Economist article that attempted to explore what would happen “if” the Chinese yuan achieved global currency reserve status.   I thought the Economist article was poorly titled: there is no “if” here in my mind; it is more a discussion of ‘when’.  Thus I felt the excellent analysis was simply couched incorrectly and I didn’t feel there was enough analysis of what might happen along the way.

In my blog I explore the relationship between the now trade-debtor status the U.S. enjoys along with the trillions of dollar denominated debt held by China.  China clearly needs to both support the dollar enough to preserve some semblance of global economic order (else its own holdings fall in value) while at the same time lower its dollar denominated debt (and/or demand for same) and most likely use some of its burgeoning exchange surplus.  Lastly I suggested that big banks must be playing currency and trade games to play out various scenarios.  This journey is going to be a challenge, and probably quite painful for many.
I noted today a really thought provoking article on CNBC that basically explores this scenario: China’s ‘QT’ [quantitative tightening] is the real global economic threat.  The article suggests that China, in its attempt to shift its debt-laden construction driven economy into a consumer driven market economy, will have to de-lever much of its debt: this means dollar denominated debt.  To ensure a ‘managed’ exchange rate China can defend its currency, when needed, by selling some its vast dollarised FX reserve.  In other words China has all the cards: though not all cards are aces.  Selling US debt won’t be easy: who else can afford it?  What happens to US interest rates if no one wants the U.S. debt?  The U.S. will be less able to live beyond its means.  The pressure on those U.S. rates will be UP, just at a time the fragile US economy might not want such increases.  

So this global re-balancing act is fraught with risks.  I stick to my point in my blog: smart bankers are working on some scenarios in order to figure out how to navigate the changes that must come.  The ‘Fed must be working on the same analysis.  Only trouble is, the ‘Fed may not have as many cards left to play.  

In my ongoing studies of UK monetary policy between the wars, and how war debts and inflation were ‘managed’ globally, it is clear from this vantage point that Britain knew it was sliding into deep financial trouble: Britain was bled dry by the war, financially.  Many allied nations owed each other vast sums in war debts; global trade was kaput and no one had any capital to buy food or raw materials needed to kick start trade.  I get the feeling that at the time the U.S. basically ‘stuck it’ to Britain, due in part to innocence (no economist had lived through such globally complex issues before) but also deliberately in that an opportunity had arisen for the U.S., and the dollar, to usurp Brtain and sterlings’ hegemony.  

The U.S. had no interest in collapsing and reconciling reciprocal war debts, that would have enabled Britain to contribute more usefully in reconstruction in mainland Europe.  This decision tied the hands of the financially strapped UK.  It paralysed progress and facilitated wild inflationary and currency swings due to the resulting global monetary instability  Of course the resulting failure of monetary policy and lack of coordination led to disastrous economic results and conditions that contributed significantly to a positive environment for polical crisis in Germany.  The result was World War Two and after that, a cleaner changeover in the order from sterling to the U.S. dollar.

We don’t have world wars to contend with, that is for sure.  But there are growing similarities between the siutation of the UK Treasury and UK economy in the 1920’s and the Fed and U.S. economy in 2010’s.  Only now it is China that is in the 1920 shoes of the U.S., and the U.S. that it is in the 1920 shoes of the UK.  Thankfully the similarities are only that, and not even universal or completely consistent in every way.  But the similarities are interesting enough that observed behavior of nations might follow.  Will China ‘stick it’ to the U.S. economy?  I don’t think so, at least not deliberately.  But deliberately China will do what it thinks it needs to do to push the yuan to currency reserve status.  And so the same ‘innocence’ we saw in the 1920’s may yet repeat.