WHICH MAJOR COUNTRIES ARE MOST LIKELY TO ENGAGE IN A COLD CURRENCY WAR?
Before diving into the ‘how’, we first explore the ‘who’ and the ‘why’ – in particular, which countries will be under more pressure to stem domestic currency strength in the coming months. In theory, exporting nations – especially those more proportionately reliant on trade growth in any future economic recovery – will be particularly wary of the challenges posed by a stronger currency to domestic exporters. Moreover, with most countries facing severe deflationary risks, an overly strong currency will be unwanted by almost all central banks in the next 3-6 months as it will only push them further away from their inflation targets.
We construct an FX Strength Aversion Index to rank which G10 countries cannot tolerate the macro costs of a strong currency right now (Fig 1). Based on our analysis, a higher score should be interpreted as countries where there is likely to be greater aversion from policymakers to future FX strength. Two currencies that standout are CHF and EUR – both of which have a relatively high trade/GDP share, a REER modestly above its 10-year average and core CPI materially below the domestic central bank’s inflation target. These factors mean that (in theory) the SNB and ECB should be more worried about the macro implications of a stronger currency in the coming months. On the other side – the likes of GBP, JPY and NZD could (in theory) see relatively less pushback against FX strength by officials based on our analysis.
ACTIVE FORWARD GUIDANCE COULD BE THE NEW WAY TO KEEP FX ARTIFICIALLY LOWER
“All war is a symptom of man’s failure as a thinking animal.” — John Steinbeck
Theory’s great – but in a Cold Currency War, it’s every country for itself. John Steinbeck’s quote can probably be extended to most policymakers. In the aftermath of major economic crises, policy decisions – in particular those that impact currencies – are typically made with domestic agendas at the forefront (rather than in a well-coordinated manner that has the least deadweight loss for the world economy). Indeed, it’s surprising to see JPY and NZD at the lower end of our FX Strength Aversion Index given that the BoJ and RBNZ have been historically more vocal about currency strength and its negative impact on the local economy. In fact, the RBNZ has already kickstarted the Cold Currency War – with the central bank expressing its desire for a weaker NZD last week.
How the ECB chooses to react to the recent EUR rally may set the tone for global FX markets in the coming months. We think the risks of more comments from central bank policymakers on FX markets in the next round of meetings in September is high. Given where the EUR ranks on our FX Strength Aversion Index – the fate of the single currency’s rally now lies in the hands of the ECB. Indeed, unlike the RBA – which has expressed only light jawboning of the AUD of late (probably as the trade-weighted AUD still remains relatively weak despite the recent uptick) – the EUR nominal effective exchange rate is at its highest in 6 years. We think EUR strength is now entering the territory deemed as the ECB’s ‘pain threshold’ – and there’s a good chance we start to see implicit concerns cited over a strong single currency. The first step towards this could come in the form of the ECB noting “an unwarranted tightening of financial conditions” (a well-known phrase to ECB watchers).
Appear weak when you are strong, and strong when you are weak.” ―
Sun Tzu, The Art of War
Beyond soft jawboning, new forward guidance policies may have an underlying currency angle to them – with more rate cut threats and tit-for-tat increases in central bank balance sheets to curb currency appreciation. The agile and speedy way in which major global central banks were able to ramp up (and scale down) asset purchases in response to the COVID-19 crisis in March is something we may need to get accustomed to. Whilst we’re actively talking about the possibility of Yield Curve Control (YCC) in the US, other countries may also choose to respond to this in their own way to avoid short-term yields and local currencies from front-running any economic recovery.
A more aggressive expansion of the ECB’s PEPP programme in 2H20 – one that sees an increase in the pace of asset purchases – would be a stronger sign of the ECB’s concern over the EUR-led tightening of EZ financial conditions. Other countries, like we’ve seen in the UK and New Zealand, may look to keep the door open to further rate cuts (deeper into negative territory) as a way to keep market expectations in check. The more control a central bank exerts on markets through its forward guidance policy choice, the more likely we’ll see policy divergences that feed through into currency markets (Fig 2).
FX VOLATILITY COULD STAY ELEVATED DESPITE FALLING RATES VOLATILITY
Whilst greater forward guidance by G10 central banks is likely to suppress overall bond market volatility – the sequential and uncoordinated nature of these policies could see FX volatility remain higher in the coming months as central banks react to one another (Fig 3). We could also see greater FX options market activity focusing on key round levels in major pairs (eg, EUR/USD 1.25 or USD/JPY 100) – as a way of playing the idea that any currency strength could be mitigated by policy actions beyond these ‘painful’ levels.
Moreover, this is not just a G10 FX phenomenon. EM countries are also limiting FX strength by using recovery periods and stronger inward capital flows to rebuild reserve buffers (Fig 4) – whilst China’s FX policy also remains crucial to broader global markets in and around the US elections (Fig 5).
Competitive devaluations won’t be an active policy objective for any developed economy in the coming months – not least given the economic and geopolitical implications of breaking current international agreements in the post-Trump protectionist policy era. But a Cold Currency War could be an unintended consequence of a future policy regime that involves the more widespread use of central bank balance sheets to exert greater control over markets. More protectionist US policies or an actively weaker Chinese yuan could also be the trigger for a ‘no-holds-barred’ FX war across the world. Nonetheless, the risks of entering a new chapter of a Cold Currency War remains particularly high.