Currency Wars

The currency wars are heating up. On Wednesday, Federal Reserve boss Ben Bernanke promised speculators he would keep interest rates low until 2014:

'To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions - including low rates of resource utilization and a subdued outlook for inflation over the medium run - are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.'

The Fed also promised to keep buying longer-term treasury securities with the proceeds from the maturing shorter-term securities in its portfolio. That, along with weaker economic growth forecasts, saw long-term bond yields fall. And when yields fall, prices rise - so bond market investors were happy.

While Bernanke didn't announce QE 3, he said it remains an option. Interest rates aren't going anywhere for another couple of years. The stock market loved it. So the Fed's announcement contained something for everyone - the bond AND stock market investor. Sweet.

We'll explain why, despite the initial reaction, you shouldn't get too excited about stocks in a moment. But the big picture issue to contemplate here is that the Fed has just fired another salvo in the global currency war.

Over the past few months, the Fed has taken a back seat to the European Central Bank (ECB). The sovereign debt crisis engulfing the region has revealed the ECB to be a formidable opponent to the Fed when it comes to money printing.

Of course, the ECB says it's simply providing 'liquidity', but everyone knows that's just another euphemism (the list grows by the day) for printing money. The ECB's actions have resulted in the euro weakening against the dollar, exactly as planned.

A weaker euro allows Eurozone nations to become more competitive in international markets. Despite Germany's apparent distaste for easy money and a weaker currency, its powerhouse export sector is perhaps the biggest beneficiary of the ECB's actions.

While the euro is not yet weak enough versus the US dollar to cause genuine concern, the ECB's newfound monetary vigour is raising eyebrows. Bernanke's promise of low interest rates for years to come and the threat of more QE was a less than subtle reminder that a weak US dollar is a long term Fed objective.

It's also an objective of the ECB, the Bank of England, the Bank of Japan, and the People's Bank of China. The problem is, they can't all be successful. Well, maybe they can against a little currency like the Aussie dollar.

The Aussie is a major beneficiary - or casualty, depending on your viewpoint - of this ongoing currency war. While all the major trading nations and blocs attempt to keep their currency weak to boost exports, capital flows to Australia as it seeks refuge from the hostilities.

The Aussie is again in the headlines as it surges higher against a range of (formally) powerful currencies. This currency strength should provide the RBA with cover to reduce interest rates at its next meeting in early February.

Up until now the RBA has refrained from getting involved in the currency wars. It sees a strong dollar as a tool to contain inflation. But China's economy is coming off the boil, easing the inflationary threat to Australia.

Such a strong Australian dollar, at a time of rising unemployment and moderating inflation, might not be such a welcome tool. So expect the RBA to join the fight this year. While they won't say so explicitly, we're betting interest rates fall to record lows in an attempt to counter the easy money policies of the world's major economies.

Everyone loses in war. In this unfolding currency war, no fiat currency can win. Currency devaluation is a crude method of stealing demand for goods and services off someone else. It doesn't create new demand or wealth. It's a zero sum game. But it does lead to increasing levels of distrust and economic animosity.

As a result, gold and silver (and maybe foreign exchange brokers as the world turns into a casino) will be the only victors. That's why both metals soared on the news of Bernanke's announcement.

And don't expect to be protected by the stock market either. If these currency wars eventually lead to high inflation, as is expected, the stock market might not be the wealth preserver (in times of inflation) it's made out to be.

The last time we experienced high inflation globally was in the 1970s. It was a terrible decade for investors. Inflation in goods and services might mean higher prices but the other side of that coin is high costs - both operating and capital costs.

It also means higher market interest rates. In a world with too much debt, the last thing we need is higher rates (or falling bond prices) in the US or Japan. But the way this currency war is unfolding, that's where we are headed.

Regards,

Greg Canavan
for The Daily Reckoning Australia

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