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Currency Wars: when Zero is too much

By John Hardy, Saxo Bank

The reason central bank policy makers are so afraid of current deflationary pressures is that a deflationary dynamic is particularly dangerous in economies with heavy public and/or private debt loads, which virtually all developed economies find themselves in. The mix in each individual economy is different, but the problem is the same. Much has been made of Japan’s enormous sovereign debt, but its private debt load is less problematic. The reverse is the case like Sweden or Canada, where public debt loads are quite modest, but where private debt levels are alarming, particularly due to housing-related lending. The UK is in double trouble, etc.

So in a world of weak growth and deflationary risks, we see the growing theme of a currency war is. That’s because the only way central bank policy makers feel they can avert deflation risks and stimulate growth at the margins, is via a devaluation of the currency relative to other currencies. The polite term for a currency war is a “competitive devaluation”. The idea is to import demand via competitive prices for exports and to keep general price levels from falling as this absorbs demand from the rest of the world to keep the economy humming, and as import prices stay firm. The problem with competitive devaluations, or a general currency war, immediately becomes clear once too many players in a global economy feel the need to weaken their currencies. Not everyone can have a weaker currency!

The first approach to ensuring an unattractive currency is to cut interest rates, as long as this doesn’t trigger excessive risk taking or credit growth domestically. But what happens once the interest rate reaches zero? That depends. In some cases, the central banks have eased policy further with enormous asset purchases, called quantitative easing, designed to inject more money into the economy via the banking system. The US Federal Reserve, Bank of Japan and now ECB have been the big proponents of QE, to varying degrees, in recent years.

Other central banks have tried intervening directly in the currency and pushed rates into negative territory, most famously in the case of the Swiss National Bank, which pushed its main rate to an impressive negative level of -0.75% last month because their attempt to keep their currency cheap through direct intervention failed spectacularly on January 15th, when the SNB felt forced to retreat from the CHF “ceiling”. Denmark has also cut rates to -0.75% to maintain its peg to the euro and Sweden’s central bank cut the deposit rate to -0.1%, its first foray. The obvious aim of this move was to weaken the Swedish krona to avoid Sweden’s increasing tilt into a deflationary dynamic. Negative rates only scare people away from holding a currency deposit. They don’t stimulate banks to lend or increase demand in the economy. And think about someone with modest savings in Switzerland. Wouldn’t it better to hold a pile of 1000-franc Swiss notes under the mattress than to keep funds in a negative yielding bank account or in a negative yielding government bond. After all, the yield on cash is at least 0.0!  Indeed negative rates are a sign of policy insanity and can’t last for long.

The problem with the current approach of purchasing assets and negative rates is again that, when everyone is doing this. (The US has been the one large central bank that has stopped QE and is supposedly approaching the inflection point when it will hike rates, but the market remains justifiably sceptical on whether and how much the Fed can hike when the rest of the world is mired in a deflationary, rate cutting and quantitative easing environment.)

So what will happen next? It is tough to say. If we carry the currency war theme to its ultimate conclusion, the risk is that currency wars escalate into trade protection wars and then even to real wars. The risk of this outcome accelerates dramatically if China takes the fateful step of revaluing its currency, the yuan. As China is the world’s factory, this would mean another massive deflationary wave washing over the world.

Even if China fails to devalue, I suspect the world will remain mired in this very low rate environment as it is hard to generate inflation when world commodity prices have dropped, growth is weak, and there is tremendous overcapacity in Asia. Also, the Fed has stopped the USD liquidity party that reigned from 2010 until late 2014 under its various iterations of QE, as the Fed finally wound down its asset purchase programme in October of last year.

From here, the currency war is only likely to continue. I suspect the Fed will be unable to normalize policy beyond a modest degree before either running into so much US dollar strength or into a new bout of economic weakness or both. Then the Fed will feel forced to re-join the competitive devaluation/currency war game. And by then, whether that is over the next six months or not for another two years, I suspect that we will have reached a point where we realize that central bank policy making of the last 5-6 years has been a horrible failure. It has merely offered a way to pretend that we don’t have an enormous debt problem and monetary system problem. We’ll rediscover the magnitude of that problem if central bank critics’ worst fears are realized: that QE and zero rates creates massive financial stability risks as asset markets become overinflated, only to crash when their faith in central bank policy fails.

So what is the best policy solution? The best policy solution would be to renormalize interest rates and to allow massive debt restructurings from the inevitable pain that this would cause. The downside would be an ugly and deep recession as over-indebted and weak players are allowed to fail. The upside would be the subsequent strong growth phase as capital is allocated appropriately, rather than unjustly to any debtor with a pulse in our crazy twilight world of zero or negative rates. But this solution is politically the most unappetizing possible so it is also the lease likely scenario.

What is more likely is that we see a spectacular blow-up in asset markets at some point that puts central banks in the hot seat. At that point, politicians around the world will take the reins away from the central banks and we’ll see a massive fiscal stimulus, with so-called “helicopter money” (the polite term is overt monetary financing) in which money is printed so stimulate demand with new public works and other government funded projects, rather than . Such a project will likely be seen under Abe in Japan first. Stay tuned. Inflation will not return in an environment of negative rates and quantitative easing. But it will return with a vengeance once we see the current paradigm fail and a switch to helicopter money.


About John J. Hardy

Originally from Texas, John Hardy graduated from the University of Texas at Austin with high honors. He has been with Saxo Bank since 2002 in various roles in FX Strategy and Asset Management. Today, John works as Head of FX Strategy. John has developed a broad following from his popular and often quoted daily FX Update column, received by Saxo Bank clients, the press and sales traders. He is a regular guest and commentator on television networks, including CNBC, CNBC Arabia and Bloomberg. Alongside his column and media appearances, John writes regular ad-hoc commentary focusing on the major currencies, central bank policies, macro-economic trends and other developments. John Hardy is available to comment on FX and the major asset classes from a macro perspective.