Central banks are locked in currency wars they cannot win
Negative-yielding bonds are taking on an ever-greater chunk of the global fixed income universe and are still failing to lift economic activity. But the market continues to call for monetary policy easing from the European Central Bank and the Federal Reserve. It is not clear why central banks continue to acquiesce.
In fairness, for the ECB, the requirement for policy action is clear, given that Germany is teetering on the brink of recession. But with Bund yields already negative across the entire curve, pushing them even lower is unlikely to forestall deflation, encourage lending or nurture an economic recovery.
Years of aggressive monetary easing by the ECB has hacked away at interest rates. Negative deposit rates, rather than supporting bank lending, have instead hindered it, rendering the central bank less able to respond effectively to negative economic events with traditional monetary policy tools. Monetary policy has reached the limits of its effectiveness.
Of course, the ECB knows all this. So why does it continue to ease?
The simple answer is that easier monetary policy tends to cheapen a country’s currency and the foreign exchange channel has become one of the few ways the ECB can juice up the eurozone economy. When central banks turned to unconventional monetary policies a decade ago, driving interest rates to record lows, and with fiscal policy constrained by politics, it left them with little choice but to use interest rates surreptitiously to target currencies in the next downturn. This is the logical next chapter to follow quantitative easing.
A weaker euro acts as a shock absorber to cushion the blow of weak internal eurozone economics by improving external dynamics. However, it initiates a domino effect whereby other central banks must also lower their interest rates in an attempt to match the efforts of their neighbours and prevent their currencies from appreciating.
The US-China trade conflict has created more complications. China’s decision to permit renminbi depreciation as an automatic stabiliser creates friction for other Asian central banks, pressuring them to engage in competitive depreciation — a kind of beggar-thy-neighbour policy. Over the past few months, a succession of central banks has eased policy. So much for solidarity in global monetary synchronisation.
For its part, the Fed is understandably reluctant to indulge in aggressive monetary stimulus.
The US consumer has remained resilient in the face of slowing economic activity, suggesting that the problem is not that interest rates are too high.
If the Fed allows interest rates to deviate too far from the ECB’s, the US dollar will strengthen. President Trump, ever alert to the risks of other countries wanting to “take advantage” of the US, is becoming increasingly irate.
Unfortunately for him, the global economic slump creates the perfect conditions for a currency war. The US will try to participate in this race to the bottom, but it will probably be the slowest competitor.
Weakening global growth is not conducive to a downtrend in a cyclical currency such as the US dollar, and safe haven flows in these times of market turbulence have clearly amplified the upward forces on the greenback.
President Trump should look in the mirror — it is the homegrown trade war that is prompting investors to seek safety. What is more, with almost $16tn bonds trading at negative yields, 10-year US Treasury yields at just 1.5 per cent are relatively high. The US cannot help but attract capital, driving the US dollar higher.
The dark side of falling interest rates is the prospect of riskier investor behaviour. With negative rates in Europe and Japan, investors are searching for any kind of yield. As a result, they have little choice but to venture into the riskier corners of the bond market.
Given regulatory constraints limiting many investors to the investment grade space, US triple-B is the natural home. But if and when the US eventually hits recession, forced sellers will find that the house has a narrow and shrinking exit door.
Fiscal stimulus is an obvious circuit breaker in this race to the bottom in currencies and yields. The market is making it easy for countries to borrow more, yet governments remain strangely reluctant.
Companies are also failing to take advantage of negative yields. To date, only a handful have locked them in the primary market. Businesses appear to be worried about the economic environment and the risks they face in taking on more leverage.
Yet, if the domination of negative yields is sustained, companies will surely focus on bond markets rather than equity markets. Why, when you can be paid to borrow, would you look to public offerings instead?
This would create a unrecognisable environment: the pipeline of investible public companies could essentially dry up. Unviable companies would be granted extended lifelines, propped up by high valuations solely based on record low debt rates.
Is this the world central banks were hoping to create when they started out on the long road of unconventional monetary policy all those years ago?
Seema Shah is chief strategist at Principal Global Investors.