It has been a brutal race to the bottom for currencies, with interest rates slashed, the lower bound tested through negative deposit rates, and monetary policy re-written to explore more inventive options. But in the latest chapter, as the ECB gets more abstract, action has swung to credit easing rather than rate cuts, which maybe – just maybe – could signal the end of the road for currency wars.
Last week, ECB president Mario Draghi served up what is thought to be the Eurozone’s final rate cut for this cycle, taking the deposit rate to minus 0.40 per cent. At the same time, he slammed the door shut on an even deeper foray into negative rates. The euro’s haywire four cents move in one session on Thursday reflected changing market perceptions about interest rate differentials and fair value for the euro. Pimco’s head of portfolio management in Germany Andrew Bosomworth spelled it out for clients: “the ECB is focused on the domestic credit channel to kick-start growth rather than lowering the euro”.
While the jury is out on whether the euro will break parity with the greenback this year, any concerted lowering of the currency may be over and other central banks may follow suit. Neil Dwane of Allianz Global Investors acknowledged the possibility of a hiatus in currency warfare. “Maybe the two major economies that needed a weaker currency, Europe and Japan, have now got one and the G20 privately agreed we’re not going to compete for the available economic growth through currencies but through quality and innovation.”
The Chinese, who are big fans of Draghi’s communication skills, may follow and hold off on further devaluation, despite huge bets by some hedge funds that the People’s Bank of China could lower the renminbi by 20 per cent or more this year. “We’ve been maintaining for some time the Chinese will not devalue,” said Dwane.
A lower euro has given a disappointing set of earnings some cover, as it has provided a tailwind for corporates earning revenue elsewhere and reporting in euros. Fund managers too may be left reviewing equity exposures if the euro stabilises or marks higher.
“The sectors that have performed well in European equities have been driven by translation effects on currency and an export driven model. Draghi is now focusing his actions on credit easing in the Eurozone fairly aggressively and that should boost domestic demand,” said Stephen Jones of Kames Capital. “You have to be careful about where you are positioned in the markets as the theme changes from currency manipulation to domestic demand.”
Draghi continued to overtly paint negative interest rates in a positive light at last week’s ECB press conference, but his reluctance to keep the option of more rate cuts alive is a nod to the naysayers. Investment and retail bankers freely acknowledge a skill set deficit in managing banks in a world of negative rates.
ECB blowing up the future pathway for negative interest rates could make investors question the scope for future easing in Japan too. Many already doubt whether the Bank of Japan can achieve anything positive with negative rates, hence the abnormal reaction of yen appreciation to extra stimulus.
Japan has been a somewhat favoured trade for fund managers allocating money in 2016, and with the correlation between the yen and Tokyo stock market still high, the result may be a stand-still at best for Japanese equities. “Until we see clarity on the Bank of Japan and the Federal Reserve, it’s hard to see how Japanese equities go higher because of the yen strengthening,” said Dwane.
All eyes are now on the Fed. But remember currency wars have caused a lot of market casualties. Reversal – if that’s what we are witnessing – could itself cause collateral damage.