Focus on sterling - watch the fall

Sterling has been the currency to watch for 2013 not yen. With an 8 percent decline to below $1.50, sterling is taking a pounding. The fundamental suggests that this trend can continue. The UK economy is set to take a triple dip since the Great Recession of 2008. More importantly, this recession fear has caused expectations for more monetary easing to rise. The MPC was mixed in their last vote 6-3 with maintaining policy. Outgoing governor Mervyn King has been one of the MPC arguing for more bond buying. The shift to easing is close and the new Governor seems to be signalling that he will use the means necessary to get the economy going. 

The BoE has admitted that inflation is likely to stay above the 2% target for at least two years. Since tightening is not in the cards, the currency is going to move lower. The BoE has not been able to hit the 2% inflation target since before 2008 so simple currency arithmetic suggests a decline. The BoE has limited creditability as an inflation fighter. This is what we may expect form other QE followers. The rest of the G10 has not followed the inflation path of the UK. The fear is that this may turn into a financial spiral of lower bond prices and currency and the BoE being the buyer of last resort of UK paper. 

Some are arguing that the current situation is part of a policy of nominal GDP targeting and an effort to improve exports. The sterling fall in not some competitive policy for devaluation. It is the result of not hitting targets, a poor economy, and strong QE.

Dollar moving to the upside

The dollar had an extremely strong month to the upside not seen since May of last year when we had ongoing problems in the EU. The combination of the belief that monetary policy expectations may not be as easy as thought earlier and the uncertainty from the Italian election has caused more investors to jump on the bandwagon of holding the dollar. The Fed minutes released suggest that continued buying of $85 billion a month may not be as certain as thought earlier. If this is true, the credit expansion for the rest of the globe will be in jeopardy.

A strong dollar is not what you would find if the world wants to take on more risk. A dollar bull market would be an interesting reversal of long-term trends and not consistent with a robust world economy.  A dollar pull will start to pull money from the other parts of the world into the US. We have seen this story before and it can be bad for leveraged bets in emerging markets. There may be carry-over to risk assets. For example, a stronger dollar with less credit expansion and slower EM growth would not be good for those commodities tied to the overall business cycle. The slowdown in EM equities is also likely. 

UK downgrade from Moody's - who cares?

Moody's dropped the UK from a triple A credit to Aa1arguing that slow growth and austerity will have a negative effect on finances for the country. So austerity will get you downgraded but continued budget deficits will also get you downgrades? 

Policies do not matter, if you have too much debt you are going down in ratings. Sluggish growth puts the country at greater risk of payment of debt but austerity will place a drag on growth so the UK is in a bind that cannot be easily avoided. The trajectory is unlikely to be changed from fiscal policy. This could be the future of many countries if Moody's applies the same logic.

This may place a greater burden on monetary policy which is pushing sterling lower. 

Currency wars and "beggar thy neighbor"

Currency wars have been and will continue to be the focus of FX markets especially with the strong currency moves we have seen year to date. However, there is a distinction between using currency as a policy for domestic improvement and movements in exchange rates which are related to monetary policy changes. some can view the end result as the same but there is a strong distinction and it is non-market related actions which are truly an issue of currency wars. Monetary policy changes will drive exchange rates but that is not the same as systematic policies to exploit export versus import prices. Charts were taken from editorial by Gavyn Davies "Who is afraid of currency wars?" ft Feb 3rd 2013

The beggar thy neightbour form of currency wars tries to improve the competitive trade position of a country versus other trading partners. This would be the policies pursued in the 1930's as an effort to change the terms of trade and then the response in a form of Tit-for-tat strategy by other countries to regain or improve their  competitive position. 

The currency wars of the 1930's was a result of sterling going off the gold standard and the resulting response of other countries to control any sterling advantage through trade restrictions.  Those countries which moved off the gold standard first were to some degree able to better weather the depression than those that used trade restrictions. Moving off the gold standard allowed monetary policy to be used  domestically without regard for currency changes. This has given some the idea that monetary policy changes that lower the nominal exchange rate will be an effective growth strategy. 

In reality the beggar thy neighbour period led to world production actually growing but trade falling. The gap between production and trade resulted in less gains from trade and a world that was economically worse off. The first figure shows the decline in world trade while the second shows the gap between production and trade. 

What is really a currency war to be worried about will be the use of capital controls or other types of regulation to change the flow of goods and money. This is financial repression on an international scope and scale. Linking to financial repression is important because capital flows are more important and larger than trade flows and it is the capital flows through trade finance that facilitate the trade flows. A currency war would exist when a country tries to improve its competitive position while also not changing domestic inflation rates. 

Monetary policy which increases domestic inflation and thus effect nominal exhcnage rates cannot really be thought of as a currency war shot or tool. The decline in the nominal exchange rate is just a result of inflation differences. Bluster may be associated with monetary policy differences but it is not the same as a trade war.