EC Another Salvo In The Currency War

Macro Strategy Report for February 2015

by Jim Welsh with David Martin and Jim O’Donnell, Forward Markets

After a deep recession took hold in the early 1990s, Japan initiated fiscal and monetary policies to resuscitate its economy and lift the veil of deflation blocking the rising sun. The BANK of Japan (BoJ) lowered short-term interest rates below 0.5% in 1995 and has held those rates near 0% since 1999. In March 2001, the BoJ launched the first quantitative easing (QE) program in central bank history.

There were a number of false starts and relapses that only made deflation more entrenched and economic growth elusive. After more than 20 years, the residual impact of all the spending programs and monetary stimulus was that Japan’s government debt-to-GDP (gross domestic product) ratio had soared to more than 210% in 2012. To put this into perspective, most economists consider a debt-to-GDP ratio of 60% or less to be healthy. With no other stimulus options available, the BoJ moved in November 2012 to significantly cheapen the value of the yen in hopes of spurring exports, economic growth and BANK.BANK After a brief growth spurt in the first three quarters of 2013, the Japanese economy fell back into recession in the third quarter of 2014. This relapse forced the BoJ to initiate another round of yen devaluation on October 31, 2014—think of a doctor using a defibrillator to start a patient’s heart.

Last year the European Union (EU) began to deal with the dreaded combination of weak economic growth and low inflation. In response, the European Central Bank (ECB) lowered its interest rate to less than 0.5% in November 2011 and finally to 0% in July 2012, so interest rates were already as low as they could go in 2014. Logistics precluded the launch of a QE program in the eurozone last year since the ECB would be required to buy the sovereign bonds of 18 different countries, a far more complicated task than the BoJ or U.S. Federal Reserve (Fed) faced.

From a fiscal point of view, there were no realistic stimulus options either. While the EU considers a debt-to-GDP ratio of 60% to be healthy, at the end of 2013 it was at 91%. Increasing government spending is problematic since spending already represents 50.5% of total EU GDP. Much like Japan had done in 2012, the EU exhausted its monetary and fiscal options by the spring of 2014.

After witnessing Japan’s battle against deflation and weak economic growth for more than two decades, the eurozone decided it did not want to follow suit. We discussed the conundrum facing the ECB in the April and May 2014 Macro Strategy Reviews (MSRs) and concluded that the ECB would convey its desire for a decline in the euro. The euro has fallen by 18% against the U.S. dollar since early May of 2014—a huge move in less than a year in the world of foreign BANK. The move created a significant increase in volatility in the largest global financial market.

Japan and the eurozone are exporting deflation to the rest of the world through the massive depreciation of their currencies. On January 16, the tentacles of deflation spread seemingly out of the blue. In the December 2014 MSR we said, “The volatility in the BANK that the BoJ and ECB have initiated is likely to intensify in coming months.” In the November MSR we noted that most change occurs incrementally over time at first, and then suddenly. These statements appear prescient especially in light of the decision on January 16 by the Swiss National Bank (SNB) to remove the cap on the Swiss franc versus the euro.

The SNB had pegged its currency at 1.20 francs per euro since September 2011. In order to maintain that level, the SNB bought euros. After ECB President Mario Draghi said the ECB would do “whatever it takes” in July 2012, the euro modestly increased in value versus the franc, so the SNB initially profited from its intervention.

The president of the SNB had reaffirmed its commitment to maintain the cap in the first half of January. That commitment evaporated after the European Court of Justice issued its nonbinding ruling that allowed the ECB to proceed with its QE program. The SNB determined that the ECB’s QE program would lead to a further decline in the euro, increasing its already significant losses.

Within minutes of the SNB’s announcement of its cap removal, the euro plunged 27% versus the Swiss franc before closing with a loss of 15% on January 16. Investors who were long the euro—expecting it to rise—or short the franc—expecting it to fall—incurred large losses. UBS, a Swiss global financial services company, estimates that the SNB incurred a paper loss of $40 billion on its euro holdings. Citibank, Deutsche Bank and Barclays were reported to have experienced combined losses that might reach $500 million and BANK broker Forex Capital Markets (FXCM) required a $300 million loan just to keep its doors open.

The biggest loser could be Switzerland’s economy since more than half of its GDP comes from exports to the EU. With the 15% rise in the value of the franc versus the euro, the cost of imports from Switzerland into the EU jumped by 15% literally overnight. This is likely to cause Swiss exports to the EU to decline or force Swiss firms to cut their prices to offset a portion of the surge in the franc. While a recession in Switzerland is unlikely in 2015, a marked slowdown in the first half of 2015 is sure to come.

Unfortunately, the BANK fallout from the rapid appreciation in the franc will extend beyond Switzerland’s borders. According to Bloomberg News, 37% (566,000) of mortgages on the BANK of Polish banks are denominated in the Swiss franc. The Polish złoty lost 21% of its value to the franc in the wake of the SNB’s decision. A homeowner with a mortgage in francs valued initially at 100,000 now owes the equivalent of 121,000 after converting the złoty into francs. If the monthly mortgage payment was 300 złotys, it is now the equivalent of 363 złotys. According to the National Bank of Hungary, more than 60% of Hungarian household mortgages are denominated in a foreign BANK, with the majority in Swiss francs. The Hungary forint has dropped by 18% versus the franc since January 16, so the same impact felt by Polish homeowners with a mortgage in francs will burden many Hungarians. As you can see, the overnight wallop of deflation that began with Japan’s decision to lower the value of the yen in November 2012 and the ECB’s devaluation of the euro will have a negative impact on more than just their economies.

U.S. Dollar and Foreign BANK

In the April 2014 MSR we wrote:

“The collateral damage that might flow from a weaker euro and stronger dollar could include renewed weakness in emerging market [EM] currencies with current BANK deficits and another decline in gold and a range of commodities, since a stronger dollar is likely to increase deflationary pressures in the global economy. There is a lot of debt denominated in dollars and most commodities are priced in dollars.”

The euro experienced a three week key reversal the week of May 9, 2014, which we discussed in the June 2014 MSR. The technical key reversal in the euro coincided with the beginning of the rally in the dollar. Based on the J.P. Morgan basket of emerging market currencies (EMCI), dollar strength has translated into a decline of 13.3% as this is written on January 26. Since May 2014, the S&P Goldman Sachs Commodity Index (GSCI) has declined by 41.5%. Certainly, a large portion of the loss was due to the drop in oil, but many other commodities have fallen, just less dramatically. Copper has declined -17.3% after falling from $3.05 a pound last May to $2.52.

As noted in previous MSRs, we expected gold to break below its support at $1,180 as the dollar strengthened. Gold bottomed on November 7, 2014, at $1,132 and has since rallied, in part due to the currency market instability ignited by the Swiss National Bank’s decision to allow the franc to float versus the euro on January 16. Interestingly, on January 15, gold jumped from under $1,230 to $1,262 after the European Court of Justice issued its nonbinding ruling that allowed the ECB to proceed with its QE program. Did the Swiss buy some gold prior to their announcement to offset a portion of its substantial euro losses? We’ll never know.