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Currency Wars? What Currency Wars?

February 12, 2013

by Christian Thwaites

of Sentinel Investments

There's much talk of currency wars right now. We think they're way overblown. The source of the problem lies with Japan, which has made explicit a strategy to lower the yen, increase domestic demand and increase inflation. It needs to do all three. The twenty year old balance sheet recession and deflation in Japan has been a costly error in targeting inflation and not much else. Over this time, the Japanese yen appreciated by around 100% to a high of ¥77 against the dollar. The attraction of the yen was certainly not its thriving economy. It was a combination of a i) deflationary wage spiral ii) a savings glut that favored domestic government bonds iii) high real rates…even today, Japan is one of the few major economies to have a positive real rate of return on its 5-year government bonds which pay around 13bps but inflation has been below zero for most of the last four years and iv) demand for a safe asset when safe assets are in short supply.

Recently, the government announced Abenomics (meaning a lower yen, higher spending and inflation). The yen dove around 13% since and stocks jumped around 16%. Here's the yen/dollar cross rate:

Source: Federal Reserve Bank of St. Louis, Economic Research

The "currency wars" started to attract attention because if Japan is forcing a quick fix devaluation to make its goods more competitive, then someone on the other side is becoming less competitive. The first places to look were China and South Korea who complained but took little action. China pegs and protects its currency so instead made a few air space incursions over Japan to send a message. And the second place was the euro which saw a 4% appreciation in less than three weeks.

So is this a currency war? Not in the same way of the frequent competitive devaluations in the 1980s or central banks targeting a specific exchange rate and standing ready to defend it…the one exception being the Swiss National Bank but the Swiss have always been different in, well, a just different way. The move into the euro is partly an ongoing policy of diversification of reserves, increased confidence in the stability of the union and, lest we forget, eurozone trade and current account surpluses. TheECBis not taking any stand on the euro. Nor is the Fed. Nor is the Bank of England. And if there's no stand and no policy, then a war can't happen. What we're seeing is a last ditch effort by Japan to get its economy growing. It should work but the long term problems, such as a shrinking workforce, a declining capital stock, run down of its overseas assets, remain.

US Economy

We're a week late on theNFPs but would add three points to the commentary. Start with demographics. The nice thing about demography is that it's quite easy to forecast. A 20-year old now will be 30 in ten years, so we know where they will be. Mortality and life expectancy grows predictably. Births are easy enough to measure. The only big variable is immigration but there's litte appetite to change long standing policies of making it highly inconvenient. So the US population is growing around 0.9% a year, participation in the labor force is declining about 0.2% a year and the net increase in labor supply is about 0.6% a year. On a labor force of around 156m, an increase of 0.6% a year requires 930,000 new jobs a year or 78,000 per month to absorb new workers. All that does is stabilize unemployment. We need more to improve it.

Another way is to continue to drop the participation rate and here something is going on. Here is participation by women in the labor force. As steady decline from a peak twelve years ago.

Source: Federal Reserve Bank of St. Louis, Economic Research

What's going on? These are guesses but a few things come to mind: i) small company hiring is slower than large companies and women participate more in smaller enterprises ii) service sector jobs have not improved iii) slower hiring or part-time work given lack of demand and uncertainty over benefit costs. It's not at all clear but the point is that if participation increases, then the new jobs number is going to have to run faster to keep up. And if it doesn't we might see good-enough new job numbers (i.e. over 150,000) but little effect on the unemployment rate. Which then means the Fed will keep easy money in place because the target of 6.5% will prove very difficult to reach.

The second point about the employment numbers was the size of the revisions. These were up. In the final quarter the first print for NFPs was 472,000. They now stand at 603,000. The revisions for the year were quite remarkable. The first print NFPs, the ones we all react to, were 1.7m or 141,000 per month. The final numbers are 2.2m or 180,000 pm for 2012. Take the difference between the 2012 rate and the 78,000 required to absorb the growing labor force and the extra is 1.2m or 0.8% of the labor force. Which is how much the unemployment rate fell in the last twelve months. So by any measure it's a slow grind.

Finally, here's the increase in employment against GDP indexed back to the start of the recession.

Source: Federal Reserve Bank of St. Louis, Economic Research

What this suggests is that employment is growing slightly faster than the GDP rate would seem to allow. These are changing rules and dynamics in the economy and the growth/employment relationship (or Okun's Law) is by no means predictable. But the risk is that lower growth (the flat blue line) may not be able to support the ongoing (upward sloping red line) rise in employment.

Elsewhere, we had a slow week. The twoISMreports (manufacturing and services) showed little change. Here they are in a rough GDP weighted index:

Source: Federal Reserve Bank of St. Louis, Economic Research

The increase in capital spending in the manufacturing sector was offset by a bigger decrease in business activity in the non-manufacturing sector. Employment held up in both series.

The trade numbers came in on Friday. These are the ones estimated by the Bureau of Economic Analysis for the "flash" GDP report that came out ten days ago and showed a dismal 0.1% decrease with trade contributing a decline of 0.25% to GDP. The good news is that the trade deficit came in at (-$38bn) compared to (-$43bn) in the prior three months. That change alone is good for a 0.5% upward revision to GDP. It was a good month for exports for materials and a slow month for imports of oil.

And one stat that looked less rosy was productivity and costs which decreased at a 2% annual rate for the fourth quarter with unit labor costs at 4.5%. In Q2, they were running at +2.2% and 1.5%. Given the upturn in employment in Q4 and the slow pace of GDP growth, these are perhaps not surprising. It may well bounce back as we see other Q4 revisions, but for now it puts a dampener on corporate profits.


A quiet EBC press conference is greatly to be desired. Rates held. Mario Draghi frowned at the rise in the euro and it corrected 2% while he spoke. Another good example of "verbal intervention." The ECB is the "tightest" central bank right now. There's no QE in effect and no growth or unemployment targets to steer policy. Success in measured not so much by improvement in the real economy but by peripheral bond yields (steady), banking reform, liquidity provisions and ongoing dovish talk. It's quite a balancing act.


We're still at the narrow range of 1.96% to 2.00% on the 10-year. There's some evidence of strong foreign buying, but that would probably be part of the currency offset trades mentioned above. Volume seems light at 70% of the last ten days. High yield bonds are under pressure with the CDX high yield [1] spread widening from its February 1st lows. The broad narrative with bonds is the trade off returns of the 10-year treasury. We have been in a 1.40% to 2.00% range since last April. There's no real big move and the market continues to thrive on anecdotes.


Enough of the rotation argument already! Yes, there have been improving flows into equities. But this is down to 401(k) rebalances, asset allocation models and some good old diversification after a solid run in bonds. Our guess is that investors are not engaged in a big bond sell-off and remain cautious on reentering an equity market that has near ruined them twice in twelve years. The 127% rise in stocks since early 2009 has not been without pain. There have been twelve up phases of between 12% and 40% and 11 down phases of -8% to -19%. It has not been a clean ride. We would await at least another month before deciding if there's any sea change in investor behavior. Don't bet on it.

Bottom Line : Earnings season is providing little in the way of surprises. About 60% of the companies in the S&P[2] have reported with an average 5% earnings surprise to the upside. Prices are barely moving in reaction. We remain overweight.

Sources: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Capital Economics, Federal Reserve Bank of St. Louis, European Central Bank, CRT Ader, FT Alphaville, FT Money Supply, ISM Chicago, US Census Bureau, US Bureau or Economic Analysis, Pantheon MacroEconomic Advisors, ISI, J.P. Morgan Market Intelligence, High Frequency Economics, Goldman Sachs, Sentinel Asset Management, Inc.

[1] The Markit CDX North American High Yield Index is a basket of 100 single name high yield credit default swaps. An investment cannot be made directly in an index.

[2] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

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