World War C: Neosho Capital On The Currency War

This summer, Brad Pitt will star in a new film called “World War Z”, an action-horror film about a post-zombie apocalypse Earth, hence the “Z” in the title. Zombie films are not our cup of tea at Neosho (we thought the genre was dead), so it is debatable whether we will see this film, but one thing is clear to us, we are perched on the precipice of “World War C”, where “C” stands for “currency”.

And that is just not our assertion: the heads of the British, Japanese, German, and Brazilian central banks have publically argued that we are, in fact, in the midst of a currency war. In its simplest terms, a currency war is a race between nations to see who can end up with the lowest relative currency value against the others. The prize, in theory, is more exports, which should mean more jobs, which should result in greater societal happiness, or at least some plutocrats getting to keep their jobs a little longer.

We believe that while we have witnessed skirmishes on the currency front, we have yet to enter a full-fledged war because the European Central Bank (ECB) and Bank of England (BoE) are not (yet) engaged in purposeful currency devaluation. Rather, since 2009, each has been pre-occupied with either saving their currency (the ECB) or saving their banking system (the BoE). The relative value of their respective currencies has not featured high on their list of priorities over the past four years.

Not so, however, for the U.S. Federal Reserve, the Swiss National Bank, the Bank of Japan, the Central Bank of Brazil, and the People’s Bank of China, all of whom have been very interested in the relative valuation of their currencies. And this is a list that matters because three of the top five global currencies are represented on that list and all of them have been engaged in competitive devaluations of their currency in order to promote their own exports.

This form of international contest should strike those with a sense of history as similar to the trade and tariff wars of the Depression Era 1930’s: “beggaring thy neighbor” in order to extract one’s own country from economic straits. In the 1930’s, the “beggaring” took the form of either abandoning the gold standard, literally blocking the importation of foreign goods, or imposing tariffs so high that imports were effectively blocked. This time around, there are no gold standards to abandon and international trade rules have become too engrained, both economically and legally, for onerous tariffs or outright bans to be practical or legal. Thus, the only economic weapon left is that of currency devaluation.

Tensions were ratcheted up a couple notches with the recent election of Shinzo Abe as Japan’s Prime Minister this past December. As a candidate, Abe explicitly and repeatedly promised to double Japan’s inflation rate target from 1% to 2% via increased central government money printing, borrowing, and spending. And while the Bank of Japan has pushed back against Mr. Abe’s proposals, we have still seen the Yen depreciate 25% against the Euro and 10% against the US Dollar since last July. In short, Japan is “all in” on making the Yen weaker and, thus, boosting Japan’s exporting companies. Can they succeed? That is to be determined, but as exchange rates show of late, the markets are taking the Abe seriously.

Meanwhile, over the past four years the ECB has been focused on propping up Greece, Spain, Italy, and Portugal in an attempt to preserve the Euro as a viable global currency. It is impossible to simultaneously prop up and devalue a currency: the monetary presses are either “on” or “off”, despite all the sophisticated instruments and acronyms of late. Further hampering the ECB’s ability to mimic the Federal Reserve and Bank of Japan’s currency devaluations is Germany’s insistence that the ECB’s monetary efforts be “sterilized”, i.e. that no new net money is injected into the system. As such, the Euro has tended to rise and fall as the chances of Greek default or further European contagion wax and wane, rather than through the perception of a deliberate weakening of the basis of the Euro.

But how long can the Frankfurt-based ECB resist the imperative to battle generally high unemployment rates and shrinking GDP, or more to the point, how long can Germany hold fast to its inflation-phobic outlook? A great North-South Divergence is occurring in Europe: Spanish unemployment rates now match those of Greece in the 25% range and France has crossed the 10% unemployment rate threshold, while German unemployment is 4.5%. The French continue to struggle to bring their fiscal deficit below 3%, while the Germans ran a budget surplus last year. French President Hollande has warned that the Eurozone’s economy could be “destroyed by the rising euro” and that the Eurozone leadership needed to set a “medium term exchange rate target” for the Euro. Though this suggestion was quickly quashed by German President Merkel, its real purpose may have been to prod the ECB to knock down the rising Euro. We also note that Merkel is up for re-election this fall, so the last impediment to the ECB’s full engagement in currency devaluation may be gone within months.

Even if the ECB remains a non-combatant in the currency wars, with Britain about to enter its third official recession since 2007, a cheaper Pound will help expand British export volumes and thus the British economy. The BoE Governor-designate, Mark Carney, due to take up his post in July, has already hinted at a more “flexible” approach to U.K. inflation than his predecessor, floating the idea that he will target nominal GDP growth, rather than inflation, as the primary factor in determining BoE monetary policy.

We believe it likely that the ECB will shift from preserving the Euro to “optimizing” it’s value for the benefit of EU outbound trade and that the BoE would likely follow suit. At that point, there is no argument that this will be a full-fledged currency war. Given the relatively mild effects to date from currency skirmishes, many might be lulled into a false sense of indifference as to this state of affairs. However, as von Moltke once said, “No plan survives first contact with the enemy”, a point re-iterated later in Mike Tyson’s “Everyone has a plan until they get punched in the mouth.” Just how would a true currency war end, we do not know

© Neosho Capital

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