The ink had barely dried on the October 24th, G-20 communiqué, aimed at averting a global trade war, before cynical currency and commodity traders began doubting its durability, and seeing it as a simple propaganda ploy. G-20 finance chiefs agreed in Gyeongju, South Korea to refrain from massively printing their currencies to promote exports, and instead, to allow markets to decide foreign exchange values.
Still, the G-20 commitment didn’t resolve the simmering dispute between China and the US, the chief protagonists in the global currency wars, with both accused of manipulating their currencies in order to underpin economic growth through cheaper exports. There are also fears that a weaker US-dollar can lead to higher costs for key commodities, such as crude oil, copper, cotton, rice, and soybeans. Capital flight into emerging currencies is also fueling bubbles in foreign stock markets.
Emerging countries in Asia and South America have blamed the currency turmoil on the Federal Reserve, which since July 21st, has been telegraphing signals to the markets, that it intends to unleash a second round of “quantitative easing” – QE-2. By weakening the US-dollar, the US Treasury tried tocorral Europe, Japan, and Asian countries behind its drive to strong-arm China into more rapidly lifting the value of the yuan. However, Asian nations fought back, through intervention in the currency markets, buying $40.2-billion in the past four weeks alone.
South Korea, the host of the G-20 meetings, was very active in the currency markets, buying .5-billion over the four-weeks ending October 22nd and now holds about 0-billion of FX reserves. However, the G-20 agreed to “move towards more market-determined exchange rates systems that reflect underlying economic fundamentals and refrain from competitive devaluations of currencies.”
In a nod to the Fed, the G-20 agreement called for “Advanced economies, including those with reserve currencies, to be vigilant against excess volatility and disorderly movements in exchange rates. These actions will help mitigate the risk of excessive volatility in capital flows facing some emerging countries.” In other words, the Fed must take foreign currency exchange rates into consideration, when it decides on the amount of US-dollars that it intends to print, under the QE-2 scheme.
The long awaited details about the size of QE-2 are expected to be announced at the Fed’s next meeting on Nov 2-3rd. When deciding upon the size of QE-2, economists at the St Louis Fed figure a commitment to purchase 0-billion of T-bonds would be the equivalent of a quarter-point drop in short-term interest rates. Likewise, 0-billion equals about 10-basis points of yield on the 10-year T-Note.
Yet a key section of the G-20 agreement that’s missing is China’s commitment to stop manipulating the value of the yuan. Geithner said China will continue to move toward a higher yuan rate versus the dollar,because it does not want the Fed to control its monetary policy. “That requires that their exchange rate move up over time as they’re now doing and we want to see that continue. They’ve got a ways to go, and I think you’re going to see them continue to move,” he said. However, the yuan’s value has dropped by a half-percent, since Geithner’s remarks.
So far, the brunt of the Fed’s QE-2 scheme has mostly fallen upon the so-called free floating currencies. The Japanese yen has risen 12% against the US-dollar, and gained 10% against the Chinese yuan this year, and as a result, growth in Japan’s exports is slowing. Earlier this week, the US-dollar tumbled to a 15-year low of 80.45-yen after the US Treasury’s 5-year yield narrowed to just +82-basis points (bps) above comparable Japanese bonds, the smallest differential in history.
Dealers in the Japanese yen are betting that the Fed’s QE-2 scheme would be in a range between -trillion and .5-trillion. Based upon these enormous estimates, dollar /yen bears have overcome every obstacle imaginable, thrown in their path by Japan’s ministry of finance (MoF), including a daily dose of verbal jawboning and threats of intervention. The Bank of Japan (BoJ) is pumping massive amounts of yen liquidity into the markets each month, by purchasing 1.8-trillion yen of government bonds (JGB’s). The central bank now holds 121-trillion (.5-trillion) of JGB’s on its balance sheet, - equal to one-third of Japan’s GDP.
The BoJ has also injected 30-trillion yen (0-billion) of liquidity into short-term bank deposits, to flood the system with yen, and engaged in outright intervention in the currency markets on Sept 15th, by dumping 2.3-trillion yen into the markets, in exchange for purchasing -billion. The BOJ is planning to launch its own version of QE-3, to counter the Fed’s QE-2, by purchasing 5-trillion yen of BBB-rated corporate bonds and second-tier commercial paper in the months ahead.
Still, despite all these intervention efforts, the US-dollar continued to sink towards its historic low of 80-yen. However, given the vast quantities of yen that’s already been injected into the markets by the BoJ, short-sellers of the dollar /yen are taking a high degree of risk, and could get badly burned, if the Fed decides to shock the markets, with a smaller than expected blast of QE-2.
Commodities have soared since late August, as G-20 central banks pump billions of paper currencies into the global money markets, to combat the threat of the Fed’s QE-2 scheme. Raw materials and crude oil prices surged after Fed chief Ben Bernanke said on August 27th, the Fed was prepared to use large scale buying of long-term Treasuries to drive down US-interest rates. Central banks in big importing economies are taking note of soaring agricultural markets.
On October 26th, China’s commerce minister Chen Deming criticized the Fed’s decision to unleash QE-2 upon the world money markets, in explicit language. “Because the Fed’s issuance of dollars is out of control, - international commodity prices are continuing to rise. China is being attacked by imported inflation. The uncertainties of this are causing big problems for Chinese companies,” Chen told the Xinhua news agency. Conversely, the US-Treasury is hoping that Beijing would see the logic of allowing the yuan to appreciate, to fend off import inflation.
Cotton and sugar futures traded in Zhengzhou and natural rubber futures traded in Shanghai soared to new record highs this week, and if sustained, could accelerate the upward trend in China’s inflation rate. China’s cotton futures soared to an all-time high of 27,980 yuan per /ton, a +20% gain in October, while sugar futures and rubber futures also hit new record highs. Rice futures for May-delivery advanced to 2,492-yuan (4) /ton, the highest level ever. Speculative inflows have also lifted corn to a record on the Dalian Commodity Exchange.
Beijing says it’ll cracking down on “abnormal” trading activities in commodity futures. Turnover on the Zhengzhou exchange has more than tripled in the first nine months of the year, with many traders using related accounts to hold positions that exceed the exchange-set limit. The exchange has reiterated that speculators are not allowed to take delivery of the commodities, and are forbidden to hold positions in contracts that will require delivery in a month. On October 19th, China’s central bank surprised with its first increase of interest rates in nearly three years, a move that reflects its concern about rising commodity prices and stubbornly high inflation.
The Shanghai red-chip Index, the larger of China’s two stock exchanges, has soared by 15% so far in October, led by energy and metal producers. Energy and material stocks have jumped 19% and 13% respectively this month, the best two performers among the 10 industry groups in the Shanghai Index. The prospect of the Fed’s QE-2 and Chinese Treasury yields that are pegged below the inflation rate, are spurring speculation in Chinese commodity producers as a hedge against inflation.
On October 27th, China’s central bank (PBoC) and the government cabinet vowed to stabilize consumer prices and curb speculation in property prices. “High grain prices and uncertainties about global commodity prices mean that inflationary pressures should not be overlooked. Quantitative easing policies adopted by major economies had pushed up global commodity prices and a relatively loose domestic monetary environment is also adding to inflation risk,” the PBoC warned.
Taken together, Beijing is signaling heightened concern over price and asset bubble risks. Yields on Chinese 7-year T-bond have risen about 25-basis points over the past four-weeks, to around 3.15% today. However, the yield is still far below the official consumer price inflation rate of 3.6%, thus the PBoC finds itself far behind the inflation curve. There’s great skepticism about Beijing’s resolve to raise interest rates high enough, to contain inflation pressures in its economy.
US Treasury Calls for Cease-fire to Currency Wars
Strangely enough, on October 19th, US Treasury chief Timothy Geithner raised the white flag, and called for a halt to devaluation the US-dollar. “It is very important for people to understand that the USA and no country around the world can devalue its way to prosperity and competitiveness. It is not a viable feasible strategy and we will not engage in it. We recognize that the US plays a particularly important special role in the international financial system because the US-dollar serves as the principal reserve asset of the global financial system. So we’re going to work very hard to make sure that we preserve confidence in the strong dollar,” he said.
On October 20th, Geithner repeated his view that China’s yuan is significantly undervalued, but suggested there is “no need for the US-dollar to sink further against the Euro and the yen.These currencies are roughly in alignment now,” he declared. Geithner emphasized the US-Treasury isn’t pursuing a deliberate policy of devaluing the dollar. Yet history shows that if tough rhetoric or verbal threats by central bankers or Treasury officials are not backed-up with concrete action, market operators usually see through the “smoke and mirrors”, and resume trading in the same direction that was in motion, before the head fakes began.
Perhaps, the only effective way that Geithner can convince skeptical FX traders that he’s really serious about defending the US-dollar, is to instruct Fed chief Bernanke to scale down the size of QE-2. Backing this view, Dallas Fed chief Richard Fisher said that while the US-economy is barely growing fast enough to create new jobs, “presently it is not clear that conditions warrant further crisis-like deployment of the Fed's arsenal.” Philadelphia Fed chief Charles Plosser is opposed to unleashing QE-2, saying the costs exceed the benefits. “There are two costs down the road: doing something that doesn’t have any effect which is bad for the credibility of the Fed, and the other cost is how complicated does it make our exit strategy?”
St Louis Fed chief James Bullard said on Oct 21st, he would vote for buying T-bonds in much smaller blocks of 0-billion, decided meeting-by-meeting, and stressed that no firm decision has been made. “No decisions will be made until we get to the November meeting. If we do decide to go ahead with QE-2, we could think in units of about 0 billion,” he said. That’s far less than the market’s expectations of an initial down payment of 0-billion for QE-2, - the so-called “big bang.”
Then on October 25th, New York Fed chief William Dudley rocked the global markets, by lowering expectations about the eventual size of QE-2. “I would put very little weight on what is priced into the market. We make our decision on what we think is the best way to achieve our mandates. With QE-2 it is a careful assessment of the costs and benefits and to try to judge whether it makes sense to do or not,” he said.
Coming from the lips of the Fed’s #2 super dove, traders began to scramble, by dumping Euros, Swiss francs, and Treasury notes. Yields on the 5-year T-note jumped 20-basis points from a historic low of 1.10%, towards 1.30%, lifting the US-dollar index, higher, and knocking gold /oz lower. Suddenly, traders began to think that QE-2 could be far less than previously estimated, with the Treasury working behind the scenes, - pulling the rug from under the feet of dollar bears.
Treasury bond yields in the British gilt and US-T-bond markets have been depressed at artificially low levels, due to the hallucinogenic effects of QE, and are hovering far below the commodity inflation rate, that’s running at +20% or higher. Yields offered by British gilts and US-T-Notes are about 75-basis points below the inflation adjusted level of equilibrium. British 10-year Gilt yields fell to a historic low of 2.80%, after the Bank of England (BoE) monetized 200-billion pounds of the British government’s debt, or equal to 90% of the budget deficit last year.
While the Bernanke Fed justifies the unveiling of QE-2 as a tool to combat the threat of deflation, or tumbling consumer prices, there few visible signs of deflation anywhere to be found in commodity markets. Instead, the Continuous Commodity Index (CCI), an equally weighted basket of 19-commodities, stands +20% higher in US$ terms, and +25% higher versus sterling from a year ago, and it’s ready to zoom higher, if the Fed decides to unleash a “big-bang” version of QE-2.
Kansas City Fed chief Thomas Hoenig is calling for the Fed to lift the federal funds rate to 1%, and says further easing would be a “dangerous gamble” that could inflate asset bubbles and create another wrenching boom and bust cycle. “If history is any indication, without an exit strategy, the natural tendency will be to maintain an accommodative policy for too long. Rather than inflation rising to 2% or 3%, and demand rising in a systematic fashion, - inflation expectations could become unanchored and perhaps increase to 4% or 5%,” Hoenig warned.
Hoenig says the size of the federal deficit, combined with QE-2 will influence inflation expectations. “Expanding the balance sheet by another 0-billion to -trillion over the next year, and perhaps keeping the balance sheet at -trillion for the next several years, or increasing it even further, risks undermining the public’s confidence in the Fed’s commitment to long run price stability, a key element of its mandate,” Hoenig warned. But alas, although Mr Hoenig is the most honest and wisest member of the Fed, unfortunately, he’s treated like the boy who cried wolf.
With the New York Fed chief instilling doubts about the eventual size of QE-2, and hinting that the outlandish expectations of $1-trillion or more, are greatly overblown, traders are now beginning to see, the extent to which, Treasury bond prices were artificially propped-up by the Fed. The unwinding of speculative long positions in T-bonds, is sending US-interest rates higher, and the gnomes of Zurich have already sliced 5-cents off the value of the Swiss franc to US$1.0065 today, falling from an all-time high of US$1.0565 on October 14th.
According to the latest JP-Morgan survey, the gap between the percentage of traders who said they are long Treasuries and the traders that are short Treasuries grew to 29% this week, the widest in sixteen-months. Thus, the stage is set for a speculative shake-out of long positions in T-bond futures. Yields on British 10-year Gilts could also climb higher, after jumping 23-bps to 3.14%, tracking the direction of US Treasury yields. If the Fed shocks the markets, with a low-ball QE-2 figure, then the Bank of England can abstain from starting its own version of QE-2.
Higher yields in the G-7 bond markets can rattle the nerves of gold bugs, sitting on a huge fortune of wealth, after the yellow metal hit record highs this month. A speculative shake-out in the precious metals is possible. Yet in the immediate aftermath of the foreign currency wars, and doubts about the durability of the G-20 cease-fire, there’s still a vast ocean of liquidity swirling in the global markets, and legions of hedge fund traders that can prop-up key commodities at highly elevated levels, and fuel inflationary pressures worldwide.
On October 25th, Bundesbank chief Axel Weber called on the ECB to return its monetary policy to normal conditions, in order to prevent inflationary pressures. “The quicker the European inter-bank lending market recovers, the quicker we should withdraw unconventional measures. Interest rates haven’t been this low since the days of Bismarck.” The ECB stopped buying sovereign debt in August, which in turn, enabled the Euro to gain 20-US-cents to $1.400. Still, the ECB is far-away, from contemplating a hike in its repo rate, now pegged at a paltry 1-percent.
What persuaded the US Treasury chief to call a cease-fire to the foreign currency wars, and request that the Bernanke Fed scale down the size of QE-2, without obtaining a clear agreement in return from Beijing, calling for a stronger yuan? Without an agreement on raising the value of the yuan, it might become impossible to stop the US-Senate from voting for tariffs on Chinese imports flooding into the United States. So far, the US-dollar is moving in the wrong direction, climbing to 6.6805-yuan today, from 6.640-yuan on October 14th.
