Currency wars

Recently, we have often spoken about QE, and how it could result in the demise of the bond vigilante (topsy turvy), and the birth of the currency vigilante. Well, we are getting very close to the presumed launch of further unconventional monetary policy by the Fed on the 3rd of November. The market is trying to work out if it’s shock and awe or a gradual siege mentality that the Fed will deploy. Quite interestingly, the Fed has been asking US bond dealers what they are expecting, and what the markets’ reaction to QE2 would be!

However, this is not a purely domestic issue. The currency vigilantes, as previously discussed, are likely to react by driving the value of dollars down, thus increasing potential inflation and growth in the USA. This is something the Fed would be keen on as long as the decline in the dollar does not become violent and disorderly.

The Fed, however, is not alone in its desire for lower unemployment in a low inflation landscape: many economies around the world face similar issues. This is best typified by Japan. The BOJ has put itself on a war footing and is ready to respond to the salvo the Fed looks set to launch on the 3rd of November. How do we know that? Well, they took no action at their last meeting on the 28th of October, but have brought forward the date of their next meeting to the 4th of  November, in order to respond to the Fed’s next round of QE.

As we know from recent currency intervention, the Japanese do not wish their currency to appreciate. So, how may they respond to the Fed? Well, presumably using simple supply-demand economics: in order to keep the yen at the same rate as the dollar they might have to simply match the Fed by printing an appropriate amount of yen, which could be described as unconventional foreign exchange intervention.

This all sounds very inflationary and very bond negative. However, if the vast sums of money that are created in the likes of the USA, Japan, and possibly the UK (70% of the G7 GDP) is initially deployed to buy back government debt, then the bond markets may have no choice but to bizarrely rally in this potentially higher inflationary environment.