If Currency Wars Have Indeed Started, This Is What Comes Next

Even as overall volatility remains tame, things are rapidly changing in the world of currency trading where FX vol has spiked to the highest level since early October after this week’s dramatic FX rollercoaster which saw the US Treasury Secretary get this close to launching currency war, and required the verbal intervention of both (a rather angry) Mario Draghi and Donald Trump himself to normalize things, if only for the time being.

While some were quick to point out that what Mnuchin did with his “weak dollar” commentary was a dramatic reversal of decades of US “strong dollar” policy (which is nothing more than lip service as Hank Paulson showed so very well when he launched QE1 in 2008), others such as FX strategist Alan Ruskin saw a more innocuous explanation: as we noted earlier, he suggested that what you have here “is two officials who like a weak(er) USD in the short-term that will help the US trade accounts and support growth, albeit to the point where strong growth will eventually support a strong USD longer-term.”

In Alan’s view this is a way of saying that in the short-term a weak USD is good for US trade, and in the long-term a strong USD is good because it is indicative of strong growth a healthy economy. Still, Ruskin concedes that that this is clearly a very confusing message to convey and it’s unlikely to either be reported or understood correctly, which doesn’t really help the message.

And then there is the less subtle explanation: that trade wars have indeed broken out. That’s the assumption used by DB’s Masao Muraki, who today writes that it his view that the Trump Administration, having completed the tax reforms, will shift focus to trade policy.

As such it will be “easy for Trump to appeal to his base, ahead of the mid-term elections in November, with trade and dollar depreciation policies.”

And while Trump clarified on January 25 and 26 that US dollar remarks made by Mnuchin were misinterpreted, the Deutsche strategist believes that despite all the rhetoric, “Trump would not want to see the dollar appreciating in the near term, considering his remarks in the past” listed below.

• 11 January 2017, U.S. Republican, Presidential candidate, Donald Trump, “Hundreds of billions with China on trade and trade imbalance, with Japan, with Mexico, with just about everybody. We don’t make good deals anymore.”, “Russia and other countries and other countries including China, which has taken total advantage of us economically, totally advantage of us in the South China Sea by building their massive fortress, total. Russia, China, Japan, Mexico, all countries will respect us far more, far more than they do under past administrations.”
• 23 January 2017, U.S. President, Donald Trump, “(Japan does) things to us that make it impossible to sell cars in Japan, and yet, they sell cars into us, and they come in like by the hundreds of thousands on the biggest ships I’ve ever seen.”, “It’s not fair.”, “If, as an example, we sell a car into Japan and they do things to us that make it impossible to sell cars in Japan … we have to all talk about that.”,

Meanwhile, commerce Secretary Wilbur Ross appears anxious to implement the pending trade measures.

So if an aggressive currency depreciation is what the Donald ordered, i.e. some version of “trade war”, what happens next?

According to Muraki, it will be all up to the Yen.

As the strategist explains, conventional wisdom speculates that tapering the monetary policy is “premised on the forecast of yen depreciation resulting from the Fed and ECB’s tapering.” However, if the opposite happens as has been the aggressive case recently, and the yen appreciates, “the BoJ would have little room to taper its monetary easing.”

Meanwhile, ECB members have already begun to talk down the euro’s appreciation, and as we pointed out, in a remarkable outburst, on Thursday ECB President Mario Draghi directly criticized Mnuchin’s comments.”

At that point, Japan may start to talk down its own currency if jawboning interventions and retaliations become commonplace again like they were in 2016 through 1H 2017.

BoJ Governor Kuroda said if there were a major change in the “economic activity and prices as well as financial market conditions,” that “main policy tool will be further cuts in the negative short-term policy interest rate and lowering the target level of the long-term interest rate.”

There are several direct consequences, or rather observations, should the BOJ get dragged into a fresh round of currency wars.

In Observation 1, Muraki explains, that any hope the BOJ would have of tapering flies out the window as it would send the Yen spiking higher at a time when the US was actively debasing the dollar. This is a problem as the Japanese central bank is rapidly running out of private bonds it can monetize and it already owns over 75% of Japan’s equity ETFs.

The yen has appreciated and banking stocks have risen since the BoJ lowered the purchasing amount of long-term JGBs on 9 January. It is generally believed that this reflected the speculation of the BoJ tapering its monetary easing. However, while such belief did have some impacts on the market, we do not believe the impacts would be large. First, the reaction is relatively limited in the yen bond market, which is most sensitive to policy changes. Second, the yen is not appreciating as significantly as the dollar is depreciating against most currencies (Figures 1-2). Third, securities and lease stocks, which tend to react negatively to tapering of monetary easing, have significantly outperformed banking stocks that tend to react positively.

We believe a more plausible explanation is some financial sub-sectors have been propped up by circulatory funds flowing into low-P/B sectors that have been lagging.

Observation 2: it would have a direct impact on the BOJ’s three monetary policy scenarios, as follows:

• (A) DB’s house view expects Haruhiko Kuroda to be reappointed as BoJ Governor, and current monetary policy to be maintained. We expect the BoJ to carry out “stealth tapering”, slowing the net increase in JGB holdings to under ¥40trn/year because the amount of JGB purchases needed for its YCC policy is declining.
  
   

• (B) We see the possibility of some leeway for the BoJ to slightly adjust YCC if long- and short-term UST yields rise and the yen weakens.

• (C) However, the yield curve could face flattening pressure if Etsuro Honda (Japan’s ambassador to Switzerland), who advocates additional easing, joins the BoJ as the successor of Deputy Governor Kikuo Iwata or in other roles. We see lower probability of Scenario B’s tapering of easing when the yen appreciates, because yen appreciation puts downward pressure on Japanese inflation and corporate earnings. We see the possibility that, if the yen appreciates significantly, discussions of additional easing (Scenario C) will likely heat up again. That said, we see a high hurdle for additional easing considering the potential negative side effects.

Which brings us to Observation 3, and the most likely outcome should the US continue to wage covert currency war: a BOJ retaliation in the form of even more QE.

Criticism of BoJ’s monetary policy. There is a possibility of the US Department of Treasury criticizing Japanese and European monetary policies for targeting currency depreciation. However, if this happens, we believe the BoJ can justify its policy because Japan’s inflation rate is much lower than that of the US and Europe.

What are the implications of currency wars for Japanese stocks?  DB calculates that if the yen were to appreciate ¥10 against the dollar, to offset the impact on Japanese stocks, US stocks would have to rise 5%.

As for the implications of currency wars on financial stocks, DB observes that FX sensitivity of banking, securities, and lease stocks is high. If the BoJ were to restrain the yen’s appreciation, the yen would depreciate but  expectations of additional easing should put downward pressure on yen interest rates. Yen interest rate sensitivity of life insurance, securities, and banking stocks is high.

In conclusion, Deutsche Bank which dreads another episode of aggressive NIRP, currency devaluation and QE-driven race to the bottom as it would mean another near-death experience for the German bank as happened in September 2016, writes that in the end, currency wars will end with winners and losers, but generally speaking, a weak US dollar with low US interest rates tend to enhance excessive liquidity, exerting a positive effect on risk asset prices.

Which, ironically, explains why in this paradoxical case, it is not an acceleration of dollar weakness that can lead to a violent end to the party, but dollar strength as Bank of America cautioned earlier , when Michael Hartnett said that the US dollar is the key catalyst: “note US-Europe FX spat sparked ’87 crash” and “higher US$ “pain trade” = risk-off coming weeks.“

So maybe this time, currency war is just what the Keynesian PhD ordered…