ECB Risks Igniting Currency War…

‘We have not had a rules-based international monetary system since President Nixon ended the Bretton Woods agreement in August 1971. Today there are compelling reasons—political, economic, and strategic—for President Trump to initiate the establishment of a new international monetary system. The current monetary regime permits governments to knowingly distort exchange rates under the guise of national monetary autonomy while paying lip service to avoiding trade protectionism. We make America great again by making America’s money great again.’ Fed nominee Judy Shelton making her job pitch via a Cato Institute essay last year

Bond markets have been caught up in aggressive front running of ECB easing, the greater fool theory being practiced on a scale of trillions. The big question now is whether markets are over discounting the impact of Fed/ECB easing in DM sovereign and credit markets – the move in peripheral debt underlines the ‘never mind the price, we can flip it to the ECB’ frenzy. This may be framed in terms of anchoring inflation expectations, but also via FX markets implies using the ECB balance sheet to grab a bigger share of weak global demand. Shelton’s views above that this is a form of de factor competitive devaluation are becoming more mainstream in Washington; it’s ominous that Trump is taking an unhealthy interest in ECB policy in his Twitter feed.

Given the current extremely low absolute level of inflation expectations and rates versus prior QE programs, diminishing returns are inevitable. Similarly, we are approaching a limit (even with tiered deposit rates) on how negative rates can go without the adverse consequences via the banking and insurance/pensions sectors overwhelming any lending or wealth effect impetus. Some central bank researchers (even at the BoJ) have belatedly begun focusing on the ‘reversal rate’ (the policy rate at which accommodative monetary policy becomes contractionary for lending). Christine Lagarde’s beach reading  should include Capitalism Without Capital: The Rise of the Intangible Economy, exploring the dematerializing nature of incremental growth, a key theme in our research.

Traditional economics is focused on managing resources in conditions of scarcity and high fixed costs, when abundance and zero or at least negligible marginal cost models are beginning to predominate. The DGSE models beloved of central banks ignore these huge structural shifts and hence the risk of unintended negative feedback loops. The ECB already faced a tricky technical challenge if it wishes to maintain an orderly, liquid Eurozone bond market. Further QE will involve difficult political trade-offs for EU governments touching on the essence of EMU; the clear danger of a divergence with US monetary policy as a catalyst for a transatlantic political confrontation may reinforce German intransigence.

For instance, buying fewer German and Dutch bonds, where the current 33% limit looms, and more Italian and French would add about €700bn to QE capacity, but the current split is based on capital contributions to the ECB. Changing it implies in the mind of a Berlin taxi driver a transfer from industrious German savers to spendthrift Italians. If the Fed simply delivers a 25bps ‘insurance cut’ In July or September, late cycle dollar resilience into 2020 will become a key risk to US growth, earnings and Trump’s re-election hopes. We’ve seen a concerted effort begin to bully currency ‘manipulators’, with wider EM Asia now (e.g. Vietnam steel tariffs) being dragged into that category. With the USD at its highest in REER terms since 2002, the US trade deficit has grown 6.4% y/y in the first five months of the year.

The Treasury has recently tightened its criteria for assessing possible currency “manipulation” in its latest Foreign Exchange Report. Of course, much of the Chinese deficit with the US is in reality a disguised Korean and Taiwanese one via reprocessing imports of high value components (notably semiconductors from TSMC and Samsung etc.) but as supply chains move out of China the true bilateral trade picture will become more obvious. The number of major US trading partners liable for scrutiny will extend well beyond China to include large current account surplus Asian countries like Thailand and Vietnam as well as Taiwan and Korea.

The Commerce Department has also proposed a regulation that would make currency “undervaluation” a countervailable subsidy, while the Treasury also cut the current account surplus threshold for triggering closer scrutiny from 3 to 2% of GDP. With the US bilateral trade balances reduced to a form of Trumpian national P&L, and the ex-oil deficit at a record, bond markets risk turmoil unless the Fed and ECB policy paths re-converge. If the White House can’t bully the Fed into matching ECB easing as an exercise in FX management, it will likely attempt via trade intervention to limit the extent of that easing.

Germany with (stalling) exports at almost 50% of GDP and domestic content in its US made cars at half Japanese levels is acutely vulnerable – pushing a further 10-20bps off Bund yields hardly justifies the growth shock risk of a full blown transatlantic tariff war. There is now a real danger that consensus hopes for the scale and impact of ECB action are overblown and yields face mean reversion volatility this summer. It may be constrained not only by its likely impotence in terms of boosting inflation expectations but the risk that asset buying proves entirely counterproductive if the US trade focus shifts from China to Europe.  If buying more BTPs implies Americans buying fewer BMWs, Lagarde will need all her famed political skills to keep Germany on board…