It's Not the 'Currency Wars,' This Is THE Currency War

It's Not the 'Currency Wars,' This Is THE Currency War
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What do you do if you find your country in the midst of a currency war? For Brazil’s Finance Minister in early 2011 the response seemed clear enough. After all, it had been Guido Mantega who had made the initial declaration. Back at the end of September 2010, once it became very clear Ben Bernanke’s Fed was about to launch a second round of “massive” “money printing”, Mantega had gone before the world’s microphones and stated his outrage.

“We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.”

From his perspective, one shared by many around the emerging market (EM) world, the purpose was textbook. The United States or Europe would attempt to get back up from the Great “Recession” on the backs of those other systems. At that early “recovery” stage, it was becoming obvious that something wasn’t right.

To begin with, how could it have been quantitative easing, what everyone assumes is money printing, if it had to be done twice? To the Brazilians and a great many more, the Federal Reserve was going to start beggaring all its neighbors to make up for its growing economic shortfall.

The Economics textbook says that a lower currency exchange rate equals stimulus. It makes your exports relatively less expensive against others on world markets, particularly when your currency is falling against the US dollar. As a consequence, your neighbors’ goods are disadvantaged.

The same textbook also claims that the offended party isn’t without recourse. A local central bank or Finance Ministry is presumed able to strike back. That’s the war part of any currency war. The issue, at least in convention, isn’t getting the thing to move; it is the same such as it is for any war, estimating prospective costs and chances for success in order to judge whether or not it is worth the fight.

From Brazil’s perspective, if Ben Bernanke wanted to drop the dollar then Brazilian monetary officials, including those at the central bank (Banco central do Brasil), would indeed fight back.

These specific countermeasures are described as currency swaps when they are, in fact, rate swaps. Brazil’s opening salvo had consisted of 20,000 reverse swap contracts whose ultimate goal was to stimulate local bank behavior. No dollars were bought by the central bank. None were sold.

Instead, for each contract Banco offered to pay the counterparty the overnight rate in reals, the local currency, against a fixed rate in dollars. The idea was to influence this future spread, called the cupom cambial, increasing the future rate therefore price of dollars against reals which would then influence the activities of banks operating in foreign currency markets.

In January 2011, utilizing reverse swaps, the goal was to make that spread increasingly unprofitable for banks obtaining dollars on global markets. The more costly the cupom cambial, the less they would sell dollars to buy reals thereby counteracting the wicked force of Ben Bernanke’s printing press.

But if the Fed was tanking the dollar, why didn’t the dollar tank? You can argue that such wasn’t the goal of US QE, still there must be something wrong with the textbook view. Whether intentional or not, by all established accounts the dollar “should” have fallen and fallen further. That’s why when Minister Mantego showed up on TV and all over the internet everyone just nodded their heads.

What’s truly interesting about this is how different it was from Brazil’s response to QE3 (and 4) only a year and a half later. In September of 2012, again confronted by what was actually the same false dawn, Bernanke’s Fed responded to mounting pressures: falling interest rates, rising eurodollar futures prices, curve distortions, even some repo problems, etc.

Unlike 2010 and QE2, however, there were no howls of foreign protest the third time around. Once damned as the aggressor in sparking a global currency war, the official world seemed to have moved on from it – without explaining why it had.

Data from Google Trends shows that over the last fifteen years search volume for the term “currency war” was highest in September 2010, as you would expect courtesy of Brazil’s Finance Minister. Second highest was February 2013.

In addition to two more QE’s in the US, the Europeans had their LTRO’s and were acting toward keeping Mario Draghi’s promise, and the Japanese were moving ever closer to the launch of QQE and its supposedly end-of-world, turbo-charged everything “money printing.” A developed world full of central banks promising to be irresponsible in 2013 more so than at any time before.

In light of what everyone said was so much heavyweight action, what chance did any EM’s stand? Their currencies were doomed to rise and wipe out the fragile recoveries in those places.

Yet, as for Guido Mantega, no burst of outrage was forthcoming. Early in 2013, Brazil’s officials were busy winding down all their previous efforts. Despite a proliferation of what only a few years earlier were taken as currency war measures aimed squarely at Brazil, Mantega had changed his tune completely.

In an interview conducted during the month when the global public was pinging Google with searches about the currency war, Mantega declared that he had succeeded in protecting domestic manufacturers by pushing the real almost 20% lower since Banco had started up its reverse swaps. No need to worry about foreign central banks, he said, Brazil’s easily got it covered.

Take that, Ben Bernanke.

Five months later, though, in August 2013 suddenly swaps. No longer of the reverse variety, Banco would start to auction $500 million a day desperate to influence local bank behavior in the opposite direction from what it was doing just months before. To motivate the cupom cambial positively, to make it more profitable for the country’s banks to import dollars.

Brazil’s currency had gone from too high to just right - and then screamed right on by just right into holy crap. 

Take that, Guido Mantega.

But it wasn’t Bernanke’s revenge, though today some still conclude that it was. The summer of the so-called taper tantrum didn’t actually end with that summer. In Brazil, by March 2015 Banco had racked up a stunning $114.9 billion (with a “B”) in outstanding rate swaps essentially subsidizing its banks’ dollar raising activities. 

And still those weren’t nearly enough. For all that had been done, the currency was at best a little lower and over more recent months, that fateful second half of 2014, falling in more determined fashion. Faced with the reality of the real’s situation, officials pulled the plug and the currency cratered in 2015 making 2013’s crisis seem like a minor speedbump.  

The economic effects in Brazil were mind-bogglingly devastating. Somehow what was once a textbook currency war had been turned completely around. Rather than having protected Brazilian manufacturers as Mantega boasted in February 2013, they had been decimated as the currency dropped further and further.

It wasn’t just Brazil, you might recall. All its neighbors were stunned and stung by the rising dollar. The upending of the Economics textbook was pretty near universal. You probably even remember the violence of another falling currency, China’s, in August of 2015. And that was only the midpoint in the yuan’s downward odyssey.

King Dollar wrecks everything; or, as I wrote last week with regard to Russia’s experience with it all the way back in 1998, a rising dollar is the world’s biggest bear to bear.

Unlike in 2010, 2013, or even 2015, global officials have finally started to come around. This rethinking began, I suppose, in its most primitive form when Guido Mantega intriguingly sat silent as QE3 was launched in the US and QQE in Japan. Central banks had been well on their way to establishing that the dollar (therefore their local currency) isn’t theirs to command, and that most definitely includes the US central bank.

Academic and official scholarship has more and more validated this obvious correlation. The dollar goes up, the global economy goes down. Neighbors don’t beggar each other because there’s nothing to gain nor lose. Everyone gets whacked by their own falling currencies, if not equally than at least in the same manner.

But what makes the dollar rise? That’s the real question. Establishing how its upward trend is harmful was the easy part. Figuring out the method to this madness will be the long march for the world’s monetary authorities, and it’s already twelve and a half years since August 9, 2007.

Brazil’s role in this global dollar system, this eurodollar system, and its unique setup teaches us something important about the way in which all this actually works. For Banco, influencing the cupom cambial is effectively either a subsidy for acquiring dollars on global markets (swaps) or a penalty (reverse swaps).

The currency’s exchange rate is nothing more than a barometer of these conditions. Are dollars easily obtained, or more difficult? If the latter, the central bank subsidy futilely attempts to address the symptoms of the more important dollar imbalance. The inevitable “devaluation” is far from the stimulus described in the textbook.

Global banks must always have dollar balances available. That’s the reserve currency’s role; its entire purpose the widespread availability so that the dollar can become the medium for exchanging goods as well as financial intentions linking often vastly different systems. To be a good reserve currency, it must be easily and readily available everywhere.

As it had been throughout most of the eurodollar market’s history. Globalization wouldn’t have happened without the sharp rise in eurodollar size and scope. There had to have been the global money behind the more and more interconnected global economy. The eurodollar was that connection.

Russia’s 1998 episode along with the whole Asian Financial Crisis had been both an outlier and a warning. It had been widespread but still isolated in systemic terms. The warning came in realizing what could happen if the whole system ran aground instead of one (at the time) small region contained within it.

For that, August 9, 2007.

When the system broke, however, being so far in the shadows has meant no alternative to it; nothing to replace the eurodollar to cure the actual disease. Central bankers keep promising to fix each’s local symptoms, coming up short every single time. That’s another primary lesson from Brazil.

You may or may not be aware that Brazilian authorities last week intervened in local currency markets again. Nothing huge, just what looks like an opening round of testing the waters and the market’s resolve.

No, not the reverse swap type, either. Though that is what mainstream commentary would have you believing. The real is falling to record lows. Brazil’s current Finance Minister Paulo Guedes, now styled the Minister of the Economy (how quaint), surely wishes the Fed would try to spark some new textbook currency war.  

Even if it was called not-QE this time.

According to the latest narrative, one that began last autumn, the world is getting better after an “unexpected” bout with what Fed Vice Chairman Richard Clarida termed global headwinds and disinflationary pressures. The former the consequences of the latter, those being the more obvious financial symptoms the rising dollar always brings with it.

Falling interest rates, rising eurodollar futures prices, curve distortions, maybe even some repo problems, etc.

What Clarida was trying to say was that in his view, one shared by the rest of the Fed’s policymakers, the global financial problem seemed to have run its course; the dollar’s uptrend broken. It was a belief widely shared among all the prominent “currency experts” who remain steadfastly bearish on the US currency – though, it is clear, for reasons that have nothing to do with what we are talking about here.

The real shame is that there are any number of ways to check on these assumptions, starting with interest rates, eurodollar futures prices, curve positions, and even the repo market. All the things that describe the liquidity situation and therefore availability within this global monetary system.

Not just as it pertains to Brazil.

It is true that curves last summer were all screaming toward the ground, indicating the approach of a seeming global abyss. It is also true that they stopped late in August.

The problem is how many especially those in official capacities took that to mean something it did not. The way the “bond market” had behaved was misinterpreted as if it had been an imminent, all-or-nothing alarm. It had sounded and then went silent, so for those who took this view the transition was a pretty clear sign of better days ahead. A scare and nothing more.

The curves themselves, however, haven’t really changed all that much in the past five months. And that in itself isn’t unusual. We’ve seen this happen before including that period in the middle of 2015 – up until that July and the few weeks preceding CNY.

What had really happened was the bond market all the way back in the middle of 2018 began to price a non-trivial chance of global liquidity problems (which could be seen in the dollar’s sudden turnaround) leading to a global downturn of some unknown proportion; these disinflationary pressures developing into strong enough headwinds which could blow the global economy into dangerous territory.

Falling interest rates, rising eurodollar futures prices, curve inversions, and repo problems together said the probability of such a fate was growing with these. The further they went, the greater the implied chance as well as its downside potential. It was that way in August and, contrary to the official assessment, is much the same today.

Take a look at the US Treasury curve or eurodollar futures; both are pricing for more Fed rate cuts to come. Not only is that, by the textbook, supposed to be dollar negative it is once more dead set against what Jay Powell (and Richard Clarida) thinks. If a recession “scare” had caused him three rate cuts he didn’t foresee nor want, what’s going on in the global economy that pulls some more out of the reluctant Chairman over the months ahead?

He might want to avoid looking at Europe and Japan. And that’s all before the coronavirus.

The dollar is rising sharply and causing all sorts of immediately negative consequences - as we can easily see via Brazil again. The disinflationary pressures are being expressed all over the place. The economic headwinds already intensified.

The main dollar exchange index, DXY, this week very nearly touched 100 for the first time in almost three years.

When Guido Mantega had originally complained about Ben Bernanke’s sinister dollar devaluation plan, the Fed’s second round of money printing, the index was 79.5 and by the time Banco had conducted the first reverse swaps it was 77.5. When the world was googling about currency wars in February 2013, though, DXY was 80 despite two more QE’s (and a Twist) in between.

It hasn’t been a straight line by any means, but there’s a reason DXY’s lowest point came on March 17, 2008 – the day Bear Stearns’ fate was announced to the world. For the dollar, and for the globalized economy, no matter how many monetary policy adjustments and QE’s, or whatever trillions in bank reserves they create, it just hasn’t been the same since.

It’s not currency wars; this is the currency war.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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