With the end of Asia’s lunar new year celebration and the return of the US and Canadian markets after yesterday’s holiday, there is full liquidity in the global capital markets for the first time in over a week.  The currencies are mixed, with the yen, sterling and the Australian dollar posting modest gains, while the euro, Swiss franc and Canadian dollar have heavier tones.

The Chinese yuan has weakened for the second day after returning from the extended holiday and is near 2-month lows.  After reversing lower yesterday, the Shanghai Composite led the regional bourses lower with a 1.9% decline.  The Composite is approaching its 20-day moving average (~2365) which it has not traded below since early December.  European equity markets are higher and the Dow Jones Stoxx 600 is up a little more than 0.5% led by consumer goods and basic materials.  Of the main industrial sectors, only telecom is lower.  European bond markets, core as well as periphery are lower.  

Broadly speaking, we identify five factors that will shape foreign exchange rates in coming days.

…..read the 5 HERE

“We can lament all we want, but ultimately, we are observers rather than instigators. We can be actors when it comes to our own wealth, seeking to protect it from the fallout of currency wars. We believe the best place to fight a currency war might be in the currency market itself, as there may be a direct translation from what we call the mania of policy makers into the currency markets. It’s not a zero-sum game, as different central banks print different amounts of money (that is, if one calls central bank balance sheet expansion money “printing,” even if no real currency is printed, but central banks purchase assets with fiat currency created on a keyboard). Equities may also rise when enough money is printed causing all asset prices to float higher, but one also takes on the “noise” of the equity markets: When no leverage is employed, equity markets are substantially more volatile than the currency markets.

Some call currency markets too difficult to understand. We happen to think that ten major currencies are much easier to understand than thousands of stocks. But nobody said it’s easy.

Calling it a race to the bottom does not give credit to what we believe are dramatically different cultures across the world. Gold may be the winner long-term, but for those who don’t have all their assets in gold, the question remains how to diversify beyond what we call the ultimate hard currency. To potentially profit from currency wars, you need to project your view of what policy makers may be up to onto the currency space. And if there is one good thing to be said about our policy makers, it is that they may be rather predictable”

Currency wars are evil

Real people may die when countries engage in “currency wars.” Countries debasing their currencies risk, amongst others:

• Loss of competitiveness
• Social unrest
• War

We discuss not only why we believe currency wars are evil, but also what investors may be able to do about them.

Loss of competitiveness

The illusory benefit of a weaker currency is to boost corporate earnings as companies increase their exports. That may well be true for the next quarterly earnings report, but ignores that their competitive position may be weakening. The clearest evidence of this is the increased vulnerability to takeovers from abroad. As the value of the U.S. dollar has been eroding, for example, Chinese companies are increasingly buying U.S. assets. The U.S. is selling its family silver in an effort to support consumption.

Importantly, when a country subsidizes one’s exports with an artificially weak currency, businesses lack an incentive to innovate. Japan is the best example: Japan’s problem is not that of a weak currency, but a lack of innovation. By weakening the yen, companies are given a free ride, taking an incentive away to engage in reform. Advanced economies, in our humble opinion, cannot compete on price, but must compete on value. European companies have long learned this, as there are rather few low-end consumer goods being exported from Germany. The Chinese have also heeded this lesson, allowing low-end industries to fail and relocate to Vietnam or other lower cost countries: China is rapidly moving up the value chain in goods and services produced. Incidentally, Vietnam has repeatedly engaged in currency devaluation, as the country mostly competes on price; in the absence of a strong consumer recovery in the U.S., we see further currency debasements in Vietnam.

In summary, market pressure to innovate is the most powerful motivation. Governments subsidizing ailing industries through currency debasement do long-term harm to their economies.

Social unrest

Currency debasement is not just bad for the corporate world: it’s particularly painful for citizens. Just ask citizens of Venezuela where the government just announced a 32% devaluation in the bolívar’s official exchange rate to the dollar. An overnight move of that magnitude is immediately noticeable, as are the negative effects on consumers, whereas gradual debasement in currencies of advanced economies are less noticeable, but ultimately have the same effect. The natural consequence of currency debasement is inflation, i.e., loss of real purchasing power; the two forces meet at the gas pump: As a currency loses value, commodities — all else equal — become pricier when valued in that currency.

Stagnant real wages in the U.S. over the past decade may in large part be attributed to the gradual debasement of the greenback, courtesy of fiscal and monetary policy. Folks whose real wages didn’t go anywhere for a decade feel cheated and are more likely to vote for populist politicians promising change. Currency debasement fosters growing income and wealth inequality and diverging political reactions, e.g., the Tea Party movement on the political right and the Occupy Wall Street movement on the political left. The rise of populism can be seen in the rise of Twitter: We sometimes quip that politicians that can distill their political message into a tweet have a better chance of being elected these days. Except that we are wrong: It’s not a joke.

In the Middle East, similar trends cause revolutions. People can be suppressed for a long time, but if they can’t feed themselves, they revolt. In the U.S., we are told food and energy is to be excluded from measuring inflation, as our economy is less and less dependent on food and energy (although curious that a record number of Americans used food stamps last year). However, in countries where large segments of the population cannot earn enough to feed themselves, currency debasement contributes to revolutions, not just the rise of populism.

War

For those that believe currency debasement is the appropriate way to escape a depression, keep in mind that the Great Depression provided a transition to World War II. Currency Wars fought in the first half of the 20th century tended to be a result of fiscal policy. For example, in 1925, the U.K. returned to the gold standard at pre World-War-I levels, although the U.K. could ill afford it. In 1931, Britain was forced to depart from the gold standard again. Japan suspended the gold standard in 1917, returned to it in early 1930, only to depart from it again in late 1931. In 1934, the U.S. dollar was devalued by 40% when an ounce of gold was officially priced at $35 an ounce, up from $20.67 an ounce. Exchange rates caught up with reality.

In today’s world, where major countries have free-floating exchange rates, monetary policies appear to be more pro-active rather than reactive. Either way, underlying fiscal or monetary policy have a profound impact on currency values, both in real (purchasing power) and relative (exchange rate) terms. Given unprecedented debt and deficit levels on the fiscal side, and aggressive central bank balance sheet expansion on the monetary side, we believe the term “currency war” is more than appropriate.

When told by Fed Chairman Bernanke that the gold standard prolonged the Great Depression, many feel as if monetary activism were a blessing rather than a curse. In our assessment, Ivory Tower economists are particularly apt at confusing cause and effect. The root causes of a depression are excessive debt, not currencies that are too strong. Currency debasement and expansionary monetary policies are attempts to socialize such debt, bailing out those that have taken on irresponsible debt burdens. But because governments tend to be in the group of those taking on excessive debt burdens, we are made to believe that such policy is for the greater good.

We respectfully disagree: Currency wars destroy wealth. Currency wars have a disproportionate impact on the poor, as they don’t hold assets whose value is inflated in nominal terms and that could buffer some of the fallout. Central banks don’t cause real wars. But monetary policy has a profound impact on the social fabric. Abstract theories about how aggressive monetary action are the remedy to depressions ignores the heavy social toll currency wars have on people. For those that argue that the social toll of a depression is greater, we respond that the best short-term policy to address economic ills is a good long-term policy. We cannot see how currency wars can be good long-term policy.

What to do about Currency Wars

We can lament all we want, but ultimately, we are observers rather than instigators. We can be actors when it comes to our own wealth, seeking to protect it from the fallout of currency wars. We believe the best place to fight a currency war might be in the currency market itself, as there may be a direct translation from what we call the mania of policy makers into the currency markets. It’s not a zero-sum game, as different central banks print different amounts of money (that is, if one calls central bank balance sheet expansion money “printing,” even if no real currency is printed, but central banks purchase assets with fiat currency created on a keyboard). Equities may also rise when enough money is printed causing all asset prices to float higher, but one also takes on the “noise” of the equity markets: When no leverage is employed, equity markets are substantially more volatile than the currency markets.

Some call currency markets too difficult to understand. We happen to think that ten major currencies are much easier to understand than thousands of stocks. But nobody said it’s easy.

Calling it a race to the bottom does not give credit to what we believe are dramatically different cultures across the world. Gold may be the winner long-term, but for those who don’t have all their assets in gold, the question remains how to diversify beyond what we call the ultimate hard currency. To potentially profit from currency wars, you need to project your view of what policy makers may be up to onto the currency space. And if there is one good thing to be said about our policy makers, it is that they may be rather predictable.

About Axel Merk

Axel Merk the president and chief investment officer of Merk Investments, the authority on currencies, and manager of Merk Funds, a suite of no-load currency mutual funds that typically do not apply leverage. 

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With the announcement this week of its massive $5 billion lawsuit against ratings agency Standard & Poor’s, the Federal Government took a bold step to squelch any remaining independence of thought or action in the financial services industry. Given the circumstances and timing of the suit, can there be little doubt that S&P is paying the price for the August 2011 removal of its AAA rating on U.S. Treasury debt? In retaliation for the unpardonable sin of questioning the U.S. Treasury’s credit worthiness, the Obama Administration is sending a loud and clear message to Wall Street: mess with the bull and get the horns. Shockingly, the blatant selectivity of the prosecution, however, has failed to ignite a backlash. But as the move violates both the spirit of the Constitution and the letter of the law in so many ways, I can’t help but look at it as a sea change in the nature of our governance. Call it Lincoln with a heavy dose of Putin.   

Given the nature of the U.S. economy during the housing mania of the last decade, charging S&P with fraud is like handing out a speeding ticket at the Indy 500. Like nearly every other mainstream financial firm in the world at the time, S&P believed that the U.S. economy rested on a solid foundation of accumulated housing wealth. By 2006, the housing market was closing out one of its best decades in memory. Developers, speculators, financiers, real estate agents, bankers and even ordinary Americans had become charmed by the easy wealth of serial home purchases. The party had been orchestrated by a cadre of politicians and regulators who wanted to keep the party going and take credit for the good times.

To a degree that few Americans understand even to this day, it was not irresponsible lending, bad ratings, or excess greed that finally doomed the mortgage market, it was the simple fact that national home prices started falling. As long as prices stayed high, refinancing would have been open to borrowers, and defaults would have been manageable. Among the hordes of analysts, academics, and reporters who covered the market there were few if any standing who believed that national home prices could fall of a cliff. I know this to be true because I spent many years trying, unsuccessfully, to warn them.

From 2005 to 2008, I made scores of appearances on national television and at investment conferences around the country in which I stated that national home prices were set to decline by at least 30% and that the resulting mortgage defaults would devastate the financial sector and bring down the economy. I may have just as well been arguing that pink unicorns were about to resurrect the Soviet Union. At the  2006 Western Regional Mortgage Bankers conference I told attendees that many highly rated mortgage-backed securities, including some rated AAA, would become worthless. My debate opponent claimed that such predictions only come to pass if “an atomic bomb landed on either Los Angeles, Chicago, or New York!”

The idea that home prices could decline at all, let alone by 30% was considered beyond serious consideration. The models used by the banks, investors, government agencies, academics, and rating agencies predicted that national home prices would continue to rise, or at least stay stable. They were ALL wrong. Calls for even a 5% decline would have put S&P in the extreme minority. I know because I WAS that extreme minority and would have noticed any company joining me.   Absent such opinions, the analyses put out by S&P, Moody’s, and Fitch were justifiable. So why pick on S&P? Perhaps because the other two agencies never downgraded U.S. government debt.

As proof of S&P’s institutional culpability, the Justice Department provided a few e-mails sent by S&P analysts during the final stages of the housing bubble. The messages contain cynical awareness that the mortgage market was built on a house of cards. So what? To avoid guilt would S&P have to prove 100% agreement among all employees? The company readily admits that it reached its opinions through a consensus and that feelings within the firm varied.  Opinions are, by definition, nuanced and varied. During the years before the crash I received emails from many people who agreed with me but who said that their friends and co-workers believed that they “were nuts” for harboring such fears. I lost count of how many people told me that  I was nuts. Many of these e-mails could have come from S&P analysts.    

At most, S&P was guilty of a culture of complacency and group think. Ironically that spirit was engendered by the bizarre regulatory environment created for ratings agencies by the government itself. In 1973, in order to “protect” investors from unregulated markets, the SEC designated certain ratings firms as “Nationally Recognized Statistical Ratings Organizations.” Thereafter, only bonds rated by sanctioned firms could be purchased by pension funds and federally insured banks. Before that time the ratings agencies were paid for their advice by bond investors. As the rule change limited the abilities of investors to choose who to ask, the ratings firms began charging bond issuers instead. This arrangement meant that interests of investors would be subordinated. In any event, the law may have mandated who could perform ratings, but it did not require anyone to take them seriously. Any decent portfolio manager recognized this conflict of interest and performed their own due diligence.

The problem was when it came to housing mortgage bond buyers who were just as clueless as the ratings agencies.  In fact, even those few buyers who knew the party would end badly, decided for themselves to keep dancing until the music stopped. It’s completely hypocritical to sue the band after-the fact. Given that the SEC required investors to use these ratings agencies, should not the Justice Department be suing them instead?

The 2011 downgrade came as the government passed a weak and inconclusive patch to the debt ceiling crisis. Now, a year and a half later, we see that they have slithered out of that poorly constructed straight jacket. With the new debt piling up faster than ever, and the government showing itself to be blatantly incapable of making hard choices, it should be clear to anyone with a half semester of accounting that the Treasury debt should be downgraded. Yes the government has a printing press, but that only means that the value of the bonds will disappear through inflation rather than default. S&P was far too lenient. 

Smaller ratings agency Egan Jones (which never had the official sanction of S&P) issued harsher reports about government debt, and they have also been duly punished for their candor. In 2011 the other major ratings agency, Moody’s, argued that the fiscal cliff deal agreed to by Congress and the President improved the country’s fiscal position and forestalled any need to downgrade Treasury debt. However, since we never actually went over that conveniently erected fiscal cliff, why has Moody’s not responded with a downgrade? Perhaps they want to stay out of court? 

Let’s hope that it is still possible to get a fair hearing in a U.S. court of law, even when squaring off against the biggest and most powerful opponent the world has ever known. But even if S&P wins, we have all already lost. If it survives it will only do so after incurring huge legal bills and seeing its share price slashed. It’s a foregone conclusion that no more downgrades will be coming.   

As countries try to weaken their currencies to boost exports, the risk of a currency war similar to events seen in the 1930s has heightened and policymakers are making sure they are on the winning side, according to Morgan Stanley.

The balance of power now rests with Japan, according to the bank, as Japan’s policy-makers’ more dovish approach looks set to bring the world a step closer to a currency war.

The Bank of Japan doubled its inflation target to 2 percent in January and made an open-ended commitment to continue buying assets from next year. This follows a leadership change, with new Prime Minister Shinzo Abe openly calling for aggressive monetary stimulus from the country’s central bank.

(Read More: Land of the Falling Yen: Japan Cheers Sliding Currency)

This move, Morgan Stanley said, is a “game changer” as Japan tries to invigorate its stagnating economy .

“If a weaker yen (Exchange:JPY=) is an important pillar of the strategy to make this export-oriented economy more competitive again, it brings into the picture something that was missing from earlier interactions among central banks of the advanced economies – competitive depreciation,” it said in a research note.

“This, in turn, takes us one step closer to a currency war.”

Manoj Pradhan, an economist at the bank details the 1930s war and highlights the lessons that we can learn from the past.

The U.K. was the first to leave the gold standard on September 19, 1931 due to painfully high unemployment. Sterling depreciated, setting off a volatile chain of events with the U.S., Norway, Sweden, France and Germany all following suit.

Those countries that moved early benefited at the expense of others on the gold bloc, a “beggar-thy-neighbor” outcome, according to Pradhan.

“Similarly, it is the domestic agenda that could drive competitive depreciation today,” he said.

“Since global demand is likely to remain sluggish, a revival of Japan’s export sector on the back of yen weakness is likely to eat into the market share of other exporters – something that could well invite measures to curb significant weakening of the yen.”

(Read More: What Could Really Spark a Currency War)

In a detailed scenario of what could follow, Pradhan highlights that the European Central Bank and theFederal Reserve would ease further, using quantitative easing to dampen euro strength and debt ceiling fears.

Capital controls could be brought in by Latin American and other Asian economies, he said, which could be transaction taxes or even some sort of verbal interaction.

“In the particularly interesting cases of Korea and Taiwan, our economist Sharon Lam believes that verbal intervention (already under way to some extent), intervention in the foreign exchange markets and capital controls represent the most likely policy reactions,” he said, adding that the emerging markets of Colombia, Mexico, Peru and Chile have even u-turned towards a more dovish stance.

(Read More: Why Currency Wars Might Be Coming)

“While a currency war is not our base case, the new-found commitment of Japan’s policy-makers does raise the risk of retaliatory action to keep the yen weak,” he said.

“The experience of the 1930s suggests to us that such large currency crises are likely triggered by domestic issues, and that they do create distinct winners and losers. EM (emerging market) policy-makers are already gearing up to make sure they remain on the winning side, but the balance of power for now rests with Japan.”

–By CNBC.com’s Matt Clinch