Currency Wars: Fed, Brexit, and Yuan Crisis Potential
Thus far, 2016 has shaped up to be an unprecedented year. The old guard of the Republican party has been usurped and a socialist insurgency has taken hold within the Democratic electorate. For the first time since the late 1930s, populist politics are in vogue, taking hold in both major political parties. These changes come on the heels of decades of globalization and lax trade policies. While these policies have been a net benefit on the global economy, jobs have been displaced as global companies search for the cheapest source of labor and countries have raced to devalue their currencies in order to keep costs below their neighbors, keeping their citizens employed.
The Economics
The most obvious and talked about perpetrator of currency manipulation is China. For years, the Chinese government has purchased outsize positions in US debt to keep their currency weak against the US dollar. When a US consumer or company purchases Chinese goods, these dollars are used by the Chinese government to purchase US debt, keeping dollars scarce. These policies have kept the Yuan plentiful in relation to the USD, helping fuel the manufacturing boom in China. Elsewhere, central banks such as the ECB have implemented asset purchase programs to keep their currencies from appreciating further. Unfortunately, currency valuation is a zero sum game; as one currency depreciates, other currencies appreciate in their relative value.
The Currency War Begins
With unprecedented action from global central banks and the increased political rhetoric surrounding currency valuation, HiddenLevers March War Room Webinar explored the implications of combative central banks and introduced our Currency Wars scenario. Using HiddenLevers, advisors can stress test portfolios against three potential outcomes to assess and manage downside risk.
The Good – Fed Stops Hiking
The Fed may opt to delay its planned rate hikes in an effort to stoke inflation and keep the value of the dollar from spiraling out of control. A halt in rate hikes would continue the same easy money policy that has fueled the bull market in US equities since 2009. Bond prices would also benefit from low rates and commodities such as oil and gold would appreciate as more money chases after a fixed stock of goods.
While QE1+QE2 pushed the value of USD down relative to other currencies, QE3 could only keep the value USD flatas other countries copied the Fed’s policy of free money and QE.
The Bad – Brexit
If the UK votes to leave the EU in June, there will be negative impacts for the Pound, Euro and regional stock markets. Investors may question the unity of the EU, pushing the dollar higher as investors sell Euros and Pounds and buy dollars. This scenario would be felt most severely in the UK and Europe and likely contained there.
The value of the Pound fell 13% against the Euro after announcement of a Brexit referendum in London. If Britain leaves the Eurozone both the Pound and Euro will likely trend lower.
The Ugly – Yuan Crisis
China finds itself in a tricky situation, over the past two decades the country has used a cheap currency to grow its manufacturing sector. These tactics have lifted millions out of poverty, but the country is now transitioning away from a manufacturing-focused economy to a more consumer-driven economy. Consumers increasingly want a strong Yuan, while producers want to keep the Yuan weak. Add in a slowing economy with multiple asset bubbles and a currency crisis in China is not out of the question. If the value of the Yuan plummets, investors would buy up US dollars and T-Bills. While this scenario would not plunge the US economy into recession, it would push global equities lower. Luckily, China’s manufacturing boom and prior monetary policies have benefitted the country with a 3.3 trillion USD currency reserve.
What’s next for global currencies?
A lax Fed, along with an increasingly rosy employment picture, should keep market participants happy. However, markets change quickly and if China’s economy continues to slow, it is possible we could experience a second and more severe Asian currency crisis. Regardless of which currency war is waged next, advisors and portfolio managers should use stress testing to determine how their portfolios will perform in the context of multiple monetary regimes and marco-economic scenarios.
Advisors can stress test a portfolio using HiddenLevers by clicking this link.
