Fans of Netflix’s hit “Stranger Things” know well how the chaos and monsters of the show’s eerie parallel universe seep into ordinary daily life, to devastating effect.
Something similar seems to be happening to one of the dominant tropes of economic policy of the past decade.
For months, financial firms, such as Goldman Sachs, have been warning that long-running “currency wars” – where countries fight to prevent a weakened US dollar and overvalued national currencies from crippling exports – could be reversed. , with frightening consequences.
Dubbing this twilight political zone “Reverse Currency War”, they believe that the reappearance of inflation, a hawkish Fed and the strength of the dollar would force governments and central banks to rethink the direction of exchange rates and race to keep pace.
In the decade since the US Federal Reserve launched a quantitative easing program of bond-buying to fight deflation, many countries have complained that the resulting dollar weakness will hurt their trade in a low growth world and would cause them to overheat trying to match the Fed’s easy money.
But that all changed after the Fed made an aggressive turn this year to rein in 40-year high inflation, with significantly higher interest rates, a halt to new asset purchases and a planned reduction in its balance sheet swollen to over $8 trillion.
The result has been a soaring dollar, whose index against other major currencies has climbed nearly 20% over the past year. U.S. trading partners have found themselves with the opposite problem of trying to prop up their currencies rather than drive them down, lest their weakness make energy and food imports even more expensive. , which would aggravate runaway inflation everywhere.
Over the past week, the “reverse currency war” has become a reality.
The turnaround was most evident with the Swiss National Bank’s sharp interest rate hike on Thursday, an apparent shift in its overall policy of suppressing the Swiss franc to fight deflation, in favor of its strength as a tool. to cool inflation matters. Given that its permanent policy has allowed it to accumulate more than $1 trillion in foreign currency reserves, this change is potentially seismic.
“This move confirms our bullish view on the franc and is the strongest evidence yet of our ‘reverse currency war’ thesis – the era of weak exchange rates is over,” the team said. Goldman’s currencies to its clients, adding that analysis showed that a 1% rise in the franc reduced inflation by 0.1/0.2 point and that the SNB would likely seek a 5% increase in the real exchange rate of the franc.
Chart: Dollar Percentage Gains Over Year – https://fingfx.thomsonreuters.com/gfx/mkt/gkplgelmevb/One.PNG
Chart: G4 inflation rate since 2000 – https://fingfx.thomsonreuters.com/gfx/mkt/zdpxoexyzvx/Two.PNG
But he is not the only one. This week, Bank of England policymakers made it clear they too were debating this upside down world, nervously watching the pound’s 14% fall against the dollar in just 12 months and a 5% of the pound weighted by commercial exchanges this year alone.
On Monday, Catherine Mann, head of BoE rate setting, said one of the reasons she voted for an interest rate hike of half a point last week, rather than a quarter The intended point was to avoid “additional imported inflation via a depreciation of the pound sterling”.
Although his colleague and BoE chief economist Huw Pill on Tuesday downplayed explicit targeting or “fine-tuning” of the pound sterling – taboo in Britain since the pound was excluded from the European Exchange Rate Mechanism – he 30 years ago – the cat seems to be out of the bag. The pound is surely an important factor.
An increasingly belligerent European Central Bank is also facing record inflation in the euro zone, exacerbated by blinding increases in energy prices and a nearly 15% fall in the euro against the dollar over the past year. last year.
Just last month, the Director General of the Banque de France, Franois Villeroy de Galhau, warned against excessive euro weakness, saying: “A euro that is too weak would run counter to our objective of stability in the euro. price.”
Japan is in a bigger mess. He talks almost daily about the excessive weakness of the yen – which is currently at its lowest level in 24 years against the dollar – even as the Bank of Japan persists in its policy of capping government borrowing rates by buying billions of dollars in bonds, in the face of creeping inflation and rising yields around the world.
It is difficult to say how long Tokyo will be able to pursue this policy while worrying about the former.
Emerging economies – many of which are facing far more destabilizing inflation in food and energy prices – have already tried to beat the Fed’s tightening last year. But greater dollar strength could force them to tighten the screws even more at a dangerous time.
The big risk in the eyes of many people is that the Fed’s promise of an “unconditional” war on inflation translates into ever-increasing pressure on the dollar in a world where rising commodity prices dollars bolsters inflation expectations everywhere and forces everyone else to emulate the US central bank, for better or for worse.
Citi strategist Ebrahim Rahbari says all this points to “excessive tightening” around the world – a “deeply worrying” outlook for global markets, with weaker stocks, flatter bond yield curves and a steep compression of financial conditions.
“The reverse currency war is heavily bearish for risk assets,” he says, adding that the currencies of the most dovish central banks and fragile economies are the most vulnerable.
If such a crisis accelerates a global recession, the pressure on the Fed to reverse course could well be strong. But war-related energy issues, tight post-pandemic labor markets and political pressures ahead of the midterm elections in the US Congress in November argue against any easing this year.
The Upside Down seems to be here to stay.
Chart: Key central bank interest rates since 2000 – https://fingfx.thomsonreuters.com/gfx/mkt/jnpweoaegpw/Three.PNG
Chart: Emerging market central bank rates since 2000 – https://fingfx.thomsonreuters.com/gfx/mkt/gdpzygmrzvw/Four.PNG
The author is chief financial and markets editor at Reuters News. All opinions expressed here are his own.