Wednesday, March 06, 2013

Investing and Trading through a Currency War

By Mitch Zacks of Zacks Investment Research

The quantitative easing programs that are being implemented by central banks throughout the developed world have the unintended consequence of potentially starting a currency war.

A currency war basically means each country is devaluing their currency in an attempt to increase exports. This potentially could have negative consequences for investors and could lead to geopolitical conflicts.

Today, we will help you understand the currency war and how investors should respond.

Dissenting Fed Opinion

The FOMC (Federal Open Market Committee) oversees the trading desk in New York that buys U.S. Treasuries and mortgage backed securities on behalf of the Federal Reserve. In the latest meeting, Fed leaders decided to take the unique action of purchasing $85 billion in bonds each month until 2014.

Esther George, who heads the Kansas City Federal Reserve Bank, spoke in a dissenting opinion in the FOMC minutes. This dissenting opinion caused a selloff in the market. Esther is concerned that the massive monthly bond buying could spark a currency war and have a negative impact on stability of the global financial market.

Unfortunately, it appears to be the case that Esther’s cause for concern is reasonable. We are currently witnessing a sizeable effect in the world’s currency markets.

How a Currency War Happens

The current interest rate environment has created an arbitrage model for traders. Essentially, profits can be made by selling short a developed country bond, and buying an emerging market bond.

Developed countries, like the U.S., Japan and European nations, have more or less guaranteed low short-term interest rates. The central banks have communicated that these cheap fixed money rates extend to 2014 or 2015. To a savvy bond trader, the cheap short-term money can be borrowed, leveraged up, and then used to buy high interest rate paying bonds from an emerging market government or corporation.

The larger the spread of the interest rates, the better the return. The better the return, the faster the hot portfolio money flows into the currency that the high interest rate bond is priced in. The net result is the emerging market currency appreciates.

For example, consider a trader that borrows from Japan’s banks with a low interest rate of less than 1%. The trader then goes to a Brazilian bank and asks to convert the Japanese currency (Yen) into Brazilian currency (real), and uses the money to buy Brazilian bonds, real estate or stocks.

This causes an inflow of capital into the Brazilian banking system causing the Brazilian real to appreciate. The appreciation of the real will cause Brazil’s exports to be relatively more expensive and Brazil’s exports to plummet. Correspondingly, Brazil’s GDP growth falls as well.

On the other hand, the shift in currency rates is beneficial for developed countries, like the U.S., as it depreciates the dollar and improves export prices. Developed countries exports become cheaper in this scenario.

In a currency war, the exports of developed countries become cheaper while the exports of emerging market countries become more expensive. This causes geopolitical conflicts to rise as exports by developed countries increase at the expense of emerging market exports. Unfortunately, a currency war is a zero sum game.

Emerging Market Conflict

It is important to remember that many emerging market nations, such as Brazil, have huge income inequality issues. Their leaders need strong GDP growth to deal with their citizens and to pay for their burgeoning social programs.

In other words, the artificially low interest rates created by the quantitative easing programs in the U.S. and Japan erode the developing world’s social gains. This causes internal conflict in the emerging markets which could include China, India, and South Africa.

It is possible the recent increase in Chinese computer hacking that we have seen in the U.S. has been triggered by our quantitative easing.

The net effect of a currency war is that you want to allocate more towards developed markets than emerging markets. However, we believe the current situation is more likely to result in “muddle through” economies as governments deal with the impact. Effectively, we don’t believe a full blown currency war will occur.

Will Quantitative Easing End?

In the U.S., the Fed has made it clear that quantitative easing will continue until we see a strong positive change towards the U.S. economic thresholds. We don’t foresee that landscape changing for at least a year. With sequestration occurring, and fourth quarter GDP coming in at an anemic level, we don’t expect quantitative easing to end until 2014.

Keep these broad numbers in mind: U.S. GDP growth for 2013 is expected to be +1.9%; Japan GDP growth is expected to be +1.2%; and Europe GDP is expected to be -0.5%. These poor growth numbers will keep the quantitative easing programs in place.

At the end of the day, currency effects from low interest rates should be a positive for U.S. exports and the U.S. economy. There is still a great deal of opportunity in international investments, but it is important not to over-allocate internationally despite a depreciating dollar.

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