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Insight: Currency Tensions Mounting

IMF Meetings: G3 Currency Tensions Mounting

Consensus was reached at the Shanghai G20 meeting (February 26-27) that excessive dollar strength and weakness should be avoided and that G20 members should not engage in competitive devaluations.

At the time, there was consensus among the G3 (the eurozone, Japan and the U.S.) and China that the dollar was strong and that this strength was damaging not only to the U.S., but also to the global economy and financial markets.

In combination with the other risk-off factors, the strong dollar was pushing down oil and other energy and commodity prices and leading to a further tightening of global financial conditions, via lower U.S. and global equities and sharply rising credit spreads in the U.S. and emerging markets.

The dollar strength was also leading to concerns that China could implement a destabilizing step devaluation of its currency against the U.S. dollar.

However, since then, the dollar has depreciated significantly against emerging-market currencies, and also the yen and euro. Moreover, U.S. growth and inflation and inflation expectations have risen, while macro variables in Japan and the eurozone have surprised to the downside.

The Bank of Japan and European Central Bank have remained/turned more dovish, respectively, since Shanghai. Hence, the dollar weakness can mainly be attributed to the U.S. Federal Reserve becoming much more dovish than before.

Specifically, the Fed has now signaled it will only hike the funds rate twice at most in 2016, Chair Janet Yellen has presented a very dovish message despite the stronger macro data and other Fed officials have explicitly or implicitly talked down the dollar.

This euro and yen strength is weighing on the eurozone and Japanese growth and inflation outlooks, upsetting European Central Bank and Japanese officials, with the latter perhaps the most perturbed, given the yen is rising even more than the euro relative to the dollar, and Japanese macro data are faltering to a greater extent than eurozone data.

Senior U.S. officials recognize these concerns, but note the dollar has risen considerably overall through the past couple of years against the euro and yen. They also observe pointedly that Germany and the eurozone could use fiscal stimulus to boost growth rather than merely relying on a stronger dollar, and that Japan could postpone its scheduled April 2017 tax hike to revivify its sagging domestic demand.

Eurozone Threatens FX Intervention; Japan Ready to Do More

In light of this, European Central Bank officials have signaled that it would be within the Bank’s mandate to purchase foreign assets as part of its quantitative easing program, rather than just euro-denominated assets. However, we regard this as merely a negotiating tactic ahead of the IMF meetings, rather than an indication that the “currency wars” are about to be stepped up.

With regards to Japan, when we last met with senior policy officials in mid-March, they did not explicitly discuss the yen’s appreciation. However, since then, USD/JPY has fallen to 108 from 113, and the latest Tankan survey has indicated a deterioration in the prospects for economic activity and inflation expectations. Thus, the pressure to prevent one-way bets on the currency via currency interventions has increased.

The Government Pension Investment Fund has been already active in purchasing foreign assets, but further yen appreciation could in our opinion trigger Bank of Japan intervention, either via currency intervention or more domestic monetary easing (perhaps, even a lower policy rate and more quantitative easing in the form of purchases of private assets). This could happen as early as the Bank of Japan’s April policy meeting. The only limits to immediate currency interventions are the IMF meetings and the forthcoming G7 meeting (in late May). However, if the market wanted to test the Bank of Japan, the Bank might need to react.

On the other hand, if the European Central Bank and, especially, the Bank of Japan move forward on currency intervention, we think the Fed would likely react by further delaying its policy tightening, thus potentially weakening the dollar still further.

IMF Spring Meetings: A Chance for a Deal

These currency tensions need to be eased to avoid reviving the currency wars that have been damaging for everyone. European Central Bank officials believe it is unlikely that all parties will agree on desirable currency levels. However, they note that central banks have independently conducted their own analytical studies and have likely found equilibrium exchange rates that are broadly similar, possibly showing that the dollar “should” be slightly weaker than in late February, although not as weak as it has become recently.

Therefore, we might see an “understanding” on currency policy among the G3 in the form of a more stringent commitment to avoid excessive currency volatility around these equilibrium rates, with the IMF being tasked to police the deal.

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