Having Cut Interest Rates To Zero, Central Banks Look To Cutting Currencies.
A Dangerous Tack?
By Randall W. Forsyth | 17 September 2010
There's A New Race To The Bottom.
First, interest rates were slashed by central banks in reaction to the credit crisis of 2008. Then, they ballooned their balance sheets with massive bond purchases in what euphemistically was called "quantitative easing". Now, with short-term interest rates in most major economies at or near zero percent, central banks have run out of basis points, the main weapon in their arsenal. Moreover, their QE has had far less than the expected impact.
Having run out of conventional options of lowering short-term interest rates and getting less from their relatively unconventional tool of buying bonds to bring down long-term rates, central bankers are utilizing their next option— currency intervention. That was a forecast from MacroMavens proprietress Stephanie Pomboy in her Sept. 10 missive to clients, which quickly became fact Wednesday when the Bank of Japan surprised the currency markets by intervening to drive down the yen. It was a surprise because nobody took the Japanese threats to dump yen and buy dollars seriously.
But the Bank of Japan reportedly bought an estimated ¥2 trillion, or $23 billion, worth of dollars, a hefty purchase even in the context of the multi-trillion currency market. What's even more important, the Japanese central bank left the resulting extra ¥2 trillion in the money market. Previously, the BOJ's practice had been to offset, or "sterilize," purchases of currencies with sales of securities to keep bank reserves unchanged.
| (To review, when a central bank buys an asset, be it a Treasury bill or a foreign currency, it 'creates' liquidity by issuing a check literally out of thin air, which gets deposited in the account of the bank that sold it the T-bill or currency. When a central bank sells an asset, it 'soaks up' excess liquidity by effectively removing 'cash' from circulation.) |
As ISI Group's Washington research team points out in a note to clients, Japan's forex intervention effectively was a form of QE because it wasn't sterilized. It was different from the Fed's QE in that the U.S. central bank tried to lower long-term interest rates. In Japan, the benchmark 10-year government bond yield already is close to 1%, so there's not much room for it to fall.
And with short rates already just above the floor of zero, the forex market was the main way to pump in liquidity. And, of course, Japanese exporters were bleeding with the yen at a 15-year 'high' of about ¥82 to the dollar [[the 'higher' the yen rate to the dollar, the smaller the number of yen needed to purchase a dollar: normxxx]], far from the ¥95 rate they estimate they need to be profitable. Yet there's another subtext to the Bank of Japan's currency intervention, a geopolitical one that relates to China.
Chinese authorities bought a reported ¥1.04 trillion ($12 billion) of Japanese government bonds in June and July, which at the margin would have driven up the yen's exchange rate, both relative to the dollar and by extension, the Chinese yuan. As notes Ashraf Laidi, chief market strategist of CMC Markets in London, Japan's finance minister commented, "I don't know the true intention" of China's big JGB purchases. While the BOJ's intervention was mainly assessed in terms of the yen-dollar exchange rate, "it is important to evaluate this currency dynamic from a Japan-China perspective," he writes in a research note.
Also, writes David Zervos, managing director for global-fixed income strategy at Jeffries & Co., the Japanese forex intervention was directed at China. "It was a forceful statement to the largest reserve manager in the world— 'You ain't gonna beggar this neighbor.'" Zervos cites the phrase describing the competitive currency devaluations during the 1930s, which wound up further contracting world trade even as nations tried to gain advantage for their exports to stimulate their own flagging economies.
Fast forward to the present. Thursday, Treasury Secretary Geithner called for "a sustained period of appreciation" in the yuan to eliminate the Chinese currency's undervaluation. That did little to mollify Congressional critics, such as Sen. Charles Schumer, the New York Democrat who charged "China's currency manipulation is like a boot on the throat of our recovery and this administration refuses to try to get China to remove that boot". Meantime, the decline in the dollar following the Japanese intervention also could create a lot of tensions, most notably in Europe, which hardly needs a stronger euro, Zervos also observes.
That was underscored by credit default swaps on Ireland's government debt blowing out to a record on a report speculating Eire could be on the brink of requesting assistance from the European Union or the International Monetary Fund if losses at its banks worsen. One salutary side effect [[for the Europeans: normxxx]] of the European 'sovereign-debt crisis' has been the retreat in the euro— from over $1.50 at its peak in 2009 to under $1.20 earlier this year before its recovery to $1.30— which has boosted exports, especially from Germany.
Finally, the Federal Reserve could be on the verge of launching QE2. The Federal Open Market Committee meets Tuesday, when it could announce additional purchases of Treasury securities. At the August confab, the panel said it would start replacing maturing mortgage-backed securities with Treasuries instead of letting the MBS run off.
The FOMC could also hold off any new purchases until the Nov. 2-3 meeting, which will conclude the day after the mid-term elections. Traditionally, the Fed would prefer to lay low during the political season. Any further Fed purchases of Treasuries would work against the BOJ's forex interventions by boosting dollar liquidity and, all else being equal, depressing the greenback, and in turn, boosting the yen. The BOJ's dollar purchases, meanwhile, would likely be invested in the Treasury market and help finance the trillion-dollar-plus federal budget deficit.
But there is a potential dark side, concludes Pomboy. While the worldwide push down on interest rates "unleashed a torrent of capital, lifting all economic 'boats' and bringing the world together, pushing down [currencies] will tear the world apart. Everybody can lower rates simultaneously. Everybody cannot debase their currencies at once."
Having the world's reserve currency gives the U.S. the advantage in this race to the bottom. But the destruction of the world's reserve currency threatens to end the Era of Globalization, Pomboy concludes, and with it the quality-of-life-enhancing disinflation and productivity that it brought. One reason for optimism that won't happen is that policy makers seem to have learned from history and seem intent not to repeat the mistakes of the past. [[But domestic political realities may dictate otherwise.: normxxx]]
The rapid, forceful and internationally coordinated response to the near meltdown of the global financial system in 2008 was to avoid a rerun of the 1930s and the failures of policy then. The collapse of international trade then resulting from the waves of currency crises and other protectionist measures transmitted the Great Depression around the globe; that is another lesson learned from that era. Nevertheless, the path of least resistance for paper currencies is lower while governments fight over shares of stagnant economies. That seems to be the message of gold's rally.
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