The US can win the currency war – but it'll regret it

The world's central banks are in a race to reflate their countries' economies by weakening their currencies. And no-one is trying harder than the US Federal Reserve. But even if it wins, the effects will be hugely damaging, says John Stepek.

I'm at the tail end of the generation that still remembers vaguely what it was like to live in a world where the big overshadowing fear behind the daily headlines was nuclear apocalypse, rather than climate change, or total economic collapse.

The optimists' argument against the idea that we'd end up blowing ourselves and each other up was that "no one would be crazy enough to do it". The doctrine of 'mutually assured destruction' the fact that as soon as you launched one missile, the other side would fire off ten in your general direction would prevent anyone from pressing the big red button.

And luckily enough, the USSR didn't survive quite long enough for either side in the Cold War to produce such a leader.

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Sadly, today's currency wars are different. Everyone knows that a race to the bottom will be hugely damaging. But what can the rest of us do when the biggest currency of all the US dollar is run by Ben Bernanke, who once theorised about dumping helicopter-loads of money into the streets.

'Blackhawk Ben', as he's been nicknamed by traders, has certainly persuaded investors that he's more than willing to sacrifice the dollar to reflate the US economy whatever the cost...

What's going on in the currency markets?

From a sterling investor's point of view, the currency markets are a pretty confusing place to be at the moment. On the one hand, the pound is really quite strong against the dollar. It's sitting at around $1.60 well up from recent lows of below $1.45.

On the other hand, anyone planning a holiday to Europe will be feeling a bit strapped. A friend went to exchange £250 in spending money for a trip to Spain yesterday. He came back with the grand sum of €260.

So what's going on?

It's simple. Currency markets are just heeding the one market mantra that has been drummed into every investor's head over the past decade: "Don't fight the Fed."

It's never great news to find that you're on the opposite side of a trade to a major central bank. The likes of George Soros can pull it off occasionally, particularly if a government is embarking on actions that are clearly doomed (such as the defence of sterling with unbearably high interest rates in 1992).

However, if a central bank is trying to demolish its currency, rather than support it well, that's harder to argue with. After all, for every piece of paper money you can buy, a central bank can print two.

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Who's winning the currency war?

But with almost every country in the world aiming for a weaker currency, who wins? For now, it's all about conviction.

The euro is strong, because everyone knows that the member governments and the European Central Bank (ECB) are desperate to defend its very existence. Its Frankenstein nature makes it the most vulnerable currency, in that the euro may one day no longer exist.

But for now that fact also makes it one of the strongest. A weak euro would be very helpful for the peripheral countries (not to mention German exporters). But it could also turn into a self-fulfilling prophecy. So the ECB will defend it for as long as it can.

The yen is strong because no one believes the Japanese have any real stomach for this fight. They're just not trying hard enough to weaken the yen. And so many speculators have lost their shirts betting on Japanese inflation over the years that few souls are hardy enough to stick with what has been a losing battle for so long.

As for the pound the Bank of England is quite a tricky player. If you had to play poker with a table full of central bankers, I reckon Mervyn King is the man who'd give you the most trouble. Mr King talks like a responsible custodian of the nation's money. He speaks out against asset bubbles. He frets about inflation, but comes out with many believable reasons as to why our biggest enemy is deflation. Of course, idiot lieutenants like Charles Bean then go and spoil it all for King by telling the truth about the Bank's motivations for ignoring inflation.

But if anything lies at the heart of sterling's wobbles just now, it's probably more hesitancy ahead of the October Spending Review. The government has talked a big game, but there's a sense that the cuts are not going to be as big or as drastic or as money-saving as markets might have once expected. We'll see the reaction on Tuesday.

The US is showing most commitment to debasing its currency

For now, the Fed is the outright winner in the currency wars. No one has shown more commitment to currency debasement than Ben Bernanke. And that matters.

Why? Ask Richard Koo, economist at Nomura. He's seen as a bit of a guru on Japan's economic situation. He coined the term 'balance sheet recession' to describe circumstances whereby consumers and companies entirely lose their desire to borrow, and only want to pay off debt.

In his book, The Holy Grail of Macroeconomics (that's maybe overstating the case, but it is well worth a read) Koo reckoned that it was almost impossible to encourage inflation in this case. The only way to do it, would be to destroy all confidence in the currency. A central bank would have to decide to shed all credibility and convince the market that it would rather leave the currency for dead. But that would end in hyperinflation. And surely no one would be mad enough to do that?

I suspect we may find out within the next few years. This isn't the last stand for the dollar. I think my colleague Dominic Frisby is right right now, the balance of risks suggests that the greenback is due for a rebound. And the market has priced in a great deal of quantitative easing anything less than an announcement of a huge flood of money next month will likely mean a big bounce for the dollar.

But Bernanke is taking the dollar ever closer to the edge. And judging by central banking history, it's more than possible that he might just push it over.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.