Guardians of Currency Race to Debase

  By RICHARD BARLEY, WSJ.com, December 27, 2012

How to play the great reflation? Faced with a sluggish recovery, the Federal Reserve is buying yet more bonds and targeting lower unemployment; the Bank of Japan is under political pressure to be more radical; and the governor-designate of the Bank of England has floated the idea of a looser monetary policy target. The result could be a race to the bottom for currencies—but not everyone can be a winner.

The immediate focus in 2013 is likely to be on the yen. Shinzo Abe’s newly elected government has demanded the BOJ do more to pull Japan out of its slump: a higher inflation target is a possibility. Expectations of a more activist BOJ already have weakened the yen which now trades at ¥86 against the dollar compared with around ¥78 in July-October. Fair value for the yen is ¥104.65 against the dollar,Goldman Sachs GS -0.11% estimates. But the question is whether the BOJ will embrace this task wholeheartedly. Some analysts suspect the Fed’s experimental monetary policy will yet outgun the BOJ, potentially limiting yen weakness.

Meanwhile, sterling is starting to look more vulnerable. The U.K’s safe-haven status is wearing thin. Growth is limp, the government’s deficit-reduction plan is off track and the U.K.’s triple-A rating may fall next year; there is a risk that future BOE governor Mark Carney’s recent musings on changes to the U.K. inflation target could unsettle markets. With sterling making up only 5% of foreign-exchange reserves and the gilt market massively distorted by quantitative easing, the pound could come under pressure. The currency may fall to the low $1.50s from around $1.61 now, RBS thinks.

As for the euro, its main achievement in 2012 was to survive despite predictions of its demise, rising to $1.32 from a low of $1.21 as the risk premium related to the euro-zone crisis waned. But the last thing Europe needs is an appreciating currency. If the euro reaches $1.35 to $1.40, that could cause pain for exporters and politicians, ING thinks. The European Central Bank could have an unconventional tool to counter that: forcing banks to pay for the privilege of depositing funds at the central bank by introducing a negative deposit rate. So far, the ECB has appeared unwilling to take that step lightly, fearing unintended consequences.

Shinzo Abe’s newly elected government has demanded the BOJ do more to pull Japan out of its slump.

With so much liquidity sloshing around global markets, currencies of emerging-market countries where growth prospects may be brighter are likely to continue to being squeezed higher. That may lead to further interventions and efforts to stem capital flows. Currency skirmishes lie ahead.