Welcome To The Currency Wars
by Brian Rogers of Fator Securities
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” –Milton Friedman, The Counter-Revolution in Monetary Theory (1970)
Welcome to the Currency Wars
After a long and unintentionally extended (thank you Hurricane Irene) vacation in South Carolina, I am back on the desk. I was asked yesterday to comment internally on the recent decisions by both the Swiss National Bank and the Brazilian Central Bank. Both actions, in my view, have potentially exposed everyone in their respective societies to the specter of higher inflation while the benefits of these rate cuts/currency pegs primarily accrue to their export sectors. Is this a big risk? You bet it is. These central bankers are crossing their fingers and praying that inflation remains tame as the US and Europe slow down and likely enter another recession. However, what if inflation doesn’t cooperate? What if inflation remains persistently high, even as over 50% of the global economy enters a recession? How will the new consuming patterns of the approximately 2.7bn people living in China and India change historical pricing correlations? If the price action of Brent crude is any indicator, these central bankers should be afraid. Very afraid.
First off, the Swiss peg. In my opinion, it’s a sign of a very desperate central bank that is closing its’ eyes, crossing its’ fingers and betting everything on red. My bet is that they will lose control of the peg soon, likely before the end of the year. This undermines the entire notion of the Swiss franc as a ‘safe haven’ currency and will make gold and silver all that more valuable during the next crisis phase. The Swiss have now made their currency nothing more than a leg in a carry trade. By fixing a peg level, the central bank has placed a huge target on their backs and told fixed income investors to arb away! You can now borrow short-term in CHF, lend long-term in a riskier currency and know that the CHF leg of your trade is safe at 1.20.
Remember the Japanese intervention back in March as the JPY rallied after the earthquake? The government got involved in the FX markets at 79 and promptly caused a sell off that went all the way to 85.5. However, with enough time the market simply overwhelms the efforts of even the most ardent money printers. The USD/JPY is now 77.42, or approximately 2% stronger from the original point of intervention.
In Brazil, the BCB cut their short-term SELIC rate from 12.5% to 12% using the excuse that this move was needed as growth is slowing. For sure there is some truth to the idea that growth in Brazil is and will continue to slow. The recent GDP numbers came in slightly below expectations of 3.2% at 3.1%, however, this is down from an annualized number of 9.27% just going back March 2010. So the trend is clearly downward and much of this attenuation is due to the much stronger BRL which at 1.65 is fully 34% stronger than it was in December 2008 at 2.51. Also moving up slightly is the unemployment rate which has moved up to 6% after recently bottoming at 5.3%. However, offsetting this data which points to economic weakness has been some rather uncooperative inflation data. The BCB’s target inflation rate is 4.5% with the upper band at 6.5%. The problem is that all of the recent data have been coming in above the central band. Just recently the IPCA Inflation number on a YoY basis recently came in hotter than expected at 7.23%, over 73bps higher than the upper end of the band. And yet in the face of such data, they cut rates 50bps. It’s important to understand that the Brazilians and the BCB have their own nasty history with inflation in the 80s. They have spent the last few decades diligently working to build a reputation as a hawkish, inflation fighting institution. Despite this, just like the Swiss, they have in one surprise announcement thrown inflation fighting out the window in favor of a weaker currency.