Currency Wars End Game

The currency wars are intensifying. The central banks of the world are becoming increasingly desperate in their efforts to bring growth back and maintain some sort of financial stability. Alas, both objectives no longer seem to be achievable at the same time anymore.

Massive amounts of liquidity have been injected into the system through continuous rounds of quantitative easing. Despite these bold exertions, economic growth remains elusive and investors are becoming progressively apprehensive.

The Bank of Japan officially introduced negative interest rates last week. The new level will be -0.01%. Japanese lenders rushed to cut ordinary deposit rates. In most cases, this will bring a reduction from 0.02% to 0.001%.

The governments latest step, is being done to hopefully force more consumption and investment on the economy. It will cost the banks billions of dollars in profits. Whether it will make lending institutions more likely to make loans, remains to be seen.

The main exchange in Japan is down over 6%, in the past month. The Nikkei had been losing ground for most of the year, dropping below 15,000 by the middle of February. It was the lowest close since October 2014.

The main exchange has lost 13% in valuation in 2016 alone. It is down over 23% since last August, putting the composite in definite bear territory.

In anticipation of negative interest rates (NIRP) for the first time ever, yields on ten year Japanese government bonds also dropped below zero, dipping to -0.01%.

More ominous, it is the first time a G-7 nation has ever seen interest on long term bonds go into negative territory. It foreshadows an end game in the currency wars that will be disastrous not only for the leading industrial powers, but for the entire global economy.

Worse yet, even though the Bank of Japan has committed itself to expand its balance sheet by 15% of GDP (Gross Domestic Product) annually, the economy remains stagnant with exceptionally low inflation. GDP shrank an additional 1.4% in the last quarter of 2015, tipping the country into recession.

It also had the opposite intended effect on the Japanese yen. Instead of weakening further as it has done before, the currency surged on the anxiety of investors that central banks in general were running out of ammunition.

It remains to be seen if the escalating measures will bring the moribund Japanese economy, out of recession. It is a key turning point in Abenomics, the monetary and economic policy in place since Shinzo Abe’s election victory in 2012.

The new effort could actually cause the perverse effect of having the Japanese save even more, as regular investment vehicles no longer bring much of a return.

With public debt at 250% in relation to GDP, further government stimulus spending has become problematic. The country already possesses the highest rate in the developed world.

With Japan now proceeding with negative interest rates, a total of 20% of world GDP is now being produced in countries with below zero levels of interest.

The bold experiment began just a year ago, when the oldest central bank in the world Sweden’s Riksbank started with negative interest rates. This month bank officials took the level even lower dropping it from 0.35% to 0.50%.

The Swedish government felt forced to take the latest step, to stop an appreciation of their domestic currency. The krona did drop a further 1.6% against the Euro the lowest rate of exchange since last August. Yields on two year notes also went negative falling to -0.62%.

The weaker krona will help stoke inflation, but it will be merely a temporary effect. This is because there is little real wage growth and consumer prices are not increasing by very much.

There is also an increasing fear that further negative monetary moves by the central bank, actually increases the risk of finally popping the vastly overheated housing market.

The European Central Bank (ECB) had already imposed a NIRP of -0.3% last year. It had the effect of penalizing retail banks from placing deposits at the central bank.

The expectation is that Mario Draghi the President of the ECB will cut rates even further next month, in response to the latest economic conditions in the Eurozone.

European banks are already struggling to remain profitable. As the ECB continues to move ever deeper into negative territory, it places the banking system in an increasingly precarious position.

France is typical of nations in the European common currency zone. The French economy has seen little growth over the last three years and is battling the onset of deflation. President Francoise Hollande facing elections in 2017, has put his confidence in further stimulus by the central bank and maybe even lower rates of interest.

The problem for France as in most of the Eurozone, is the problem of public debt. Already exceeding the 3% of GDP agreed to by treaty, in annual outlays there is little room for fiscal stimulus.

Reforms in this sector have become vital, yet will be difficult for the present socialist government.

If there is no turn around in the second largest economy in Europe this year, the socialists will face rather dismal electoral prospects in 16 months.

Even nations that are experiencing growth within the Eurozone are counting on more quantitative easing and ever lower rates of interest from the ECB. Spain which has the second fastest growing economy after Ireland is still struggling with unemployment that exceeds 20% with youthful joblessness near twice that level.

The failure of the four main Spanish political parties to create a coalition government after elections in December, leaves the fourth largest economy in Europe vulnerable to more instability and investor anxiety.

Italy is becoming progressively unstable. The country has one of the largest public to debt GDP ratios in the world. Approaching 140% in 2016, Italy is facing financial disaster. The annual budget is already exceeding 3% of GDP.

The nation is quite vulnerable to debt deflation dynamics. That is the the Italian economy will need to service debt with a currency that is appreciating. This will make it prohibitively more expensive. Interest on the debt will eat up more and more of the national wealth. It will ultimately lead to bankruptcy.

The Italians are unlikely to grow their way out of the problem either. The GDP has fallen close to 10% in the last six years and expansion has slowed to just 0.1% at the end of 2015.

Germany the most reluctant and a harsh critic of the policies of low interest rates, fiscal stimulus and quantitative easing, seems resigned to more of the same in 2016. As the largest economy in Europe and with a national budget in balance, the country has the strongest finances in the region.

Public debt in the fourth largest economy globally, is actually in decline. German debt peaked at 80.30% in 2010. It dropped to 74.9% in 2014 and 71.6% of GDP in 2015. The government is on track to lower it still further, to below 70% in 2016.

This has been made possible as a result of strong domestic employment and a economic growth rate of 2.10% annually, in the fourth quarter of 2015. Fiscal austerity will allow Germany greater flexibility in the event of a European wide recession, either this year or in 2017.

The response of the United Kingdom is somewhat typical of countries, not in the Eurozone. Although rates of employment are on the upswing, inflation is likely to be less than 1% this year.

The British pound is already under pressure given the uncertainty of the upcoming referendum on staying in the European Economic Community (EEC).

Not wanting to be placed at a competitive disadvantage, investors are confident that the Bank of England will have no choice, but to lower the benchmark interest rate. Already at a record low of 0.5% after last year, a further reduction pushes the level ever closer to zero.

Some countries are forced into adopting NIRP. Switzerland is in this category. The Swiss adopted a rate of -0.75%, when they unexpectedly had to abandon the currency peg with the Euro, at the beginning of 2015.

The central bankers in Switzerland were hoping that these punishing rates would prevent global investors from forcing a major appreciation of the franc. It was down in a defensive measure to protect the Swiss export market.

The effort has largely failed as the Swiss franc remains quite overvalued, when measured against other major world currencies. This has been to the detriment of the domestic economy, where goods and services have become prohibitively expensive to foreigners.

Norway, which is the largest oil producer in Europe is having a difficult time. Although it has the largest sovereign wealth fund in the world at over $800 billion USD (United States Dollar), the country has been forced to drop interest rates as well, in response to lower energy prices.

The present level is now at 0.75%, but a number of analysts figure it will be the next major European country to head towards negative rates. It will slow down the appreciation of the krone, which will be a benefit to Norwegian exports.

Nations around the world are responding to the near collapse in commodity prices, which is creating havoc in a many domestic economies.

Australia for example, still has an benchmark rate of 2%. Although it is at a record low since last May, the effects of the slowdown in exports to China is putting additional pressure on the Australians to make more cuts this year. Pundits expect at least two, as global growth slows even further.

The emerging world is also attempting to adjust to a world of declining interest rates. Even nations that are attempting to raise rates like Indonesia did, are now reversing course. Such increases will become increasingly difficult to pursue, when almost everyone else is cutting rates.

The central bank of Indonesia in accordance, dropped the key benchmark by 0.5% at the beginning of the year to 7.75%

China still has an central bank interest rate above 4%, but will be increasingly tempted to keep lowering rates like they did in 2015. It will be one of the ways employed by the government to stimulate the economy. The slowdown in the Chinese economy is expected to continue dropping well below the 6.9% rate achieved last year. This was the slowest expansion since 1990.

As the world’s second largest economy and a currency (the yuan) that will soon be added in the global baskets of reserves, there is no doubt the direction they take now will have serious international consequences.

If the official rate of 6.5% growth forecast for this year is far lower, it will force the People’s Bank Of China to take more drastic measures.

It should be noted that many experts consider the published rate to be highly inflated and in fact may be as much as 50% lower, than reported by the government.

Of course, the most influential central bank (the Fed) belongs to the United States. As the world’s largest economy and the most important global reserve currency, the policy adopted by bankers there will have an enormous impact on the entire international economy.

The United States had not raised interest rates since 2006. Finally at the end of 2015, a small increase was enacted by the Federal Reserve Bank. This brought the federal funds rate to a still historic low between 0.25% and 0.5%. At a nominal rate of 0.35%, further increases were promised in 2016.

The Fed is under enormous pressure to take under consideration what further rate hikes will have on not only the American economy, but the global economy as well. The GDP advanced by 2.4% in both 2014 and 2015. Although it is true that the previous year results, may yet undergo further revisions moving forward.

Given the increasing market instability and an increasingly likelihood of a recession later this year or in 2017, it looks like further interest rate increases will be delayed. It will be difficult to try normalization of interest rates, when your major trading partner Canada is moving in the opposite direction.

The country to the north of the United States, is expected to cut rates from 0.5% to zero or even into negative territory.

Canada is technically already in recession and the new Liberal government under Trudeau which was installed last November, is likely to be in favor of more easing in monetary policy.

The only nations in the world that are increasing domestic interest rates at this time, are those that are combating serious inflation as is the case in Brazil or in Venezuela. Everywhere else for the most part, is observing a continuous downward trend.

The present beggar thy neighbor policy in interest rates, is a repeat of the actions taken in regard to tariffs during the Great Depression in the 1920’s and 1930’s.

As each country raised taxes on imports to protect domestic industries, the next country felt forced to follow suit. In the end, it led to an almost complete collapse in international trade.

This is the same situation with interest rates. Now that the United States Federal Reserve Chair Yellen will not rule out negative interest rates as a possible policy prescription, it leaves the door open to an endless cycle of cuts, that will further debase national currencies.

Negative rates of interest are creating distortions in the world economy and have short lived positive effects in individual countries. This is because as one nations lowers their rates, others soon follow.

What is the end game in these currency wars? Consumers and investors eventually will lose confidence in the major currencies of the world. This will end with a collapse in monetary valuation and a worldwide financial panic, never seen on such a scale before. There will be a headlong rush into precious metals, commodities and other tangible assets of value, as money loses any real worth.