International Forecaster Weekly

The Value of Currency in an Upside Down Universe

In a regular universe a rising currency is a sign that the market values the strength of your economy and the stability of your government. In our upside-down universe, however, a rising currency is merely a sign that you have the nicest looking economy in a rough neighbourhood and that your competitors' governments are likely to fall apart slightly quicker than your own.

James Corbett | May 18, 2013

In an upside-down universe, nothing is as it seems. Black is white, up is down, cats marry dogs and television sitcoms are actually funny. Well, I don't know much about sitcoms, but economically speaking it can no longer be doubted that we live in an upside-down universe.

            Case in point. In a regular universe a rising currency is a sign that the market values the strength of your economy and the stability of your government. In our upside-down universe, however, a rising currency is merely a sign that you have the nicest looking economy in a rough neighbourhood and that your competitors' governments are likely to fall apart slightly quicker than your own. In other words, a rising currency in this universe is not necessarily a sign of strength.

            This is the situation we see developing in the USD as the greenback rises to 3-year highs not on the strength of its economic fundamentals (soaring unemployment, historic levels of Americans on food stamps, lacklustre retail performance) but solely on the fact that its main currency competitors are doing so poorly. That would of course be the Japanese Yen, which is falling in direct proportion to the skyrocketing Nikkei (and skyrocketing JGB volatility... but more on that later) and the plummeting Euro, which has just hit a six-week low as the ECB floats the possibility of introducing negative deposit rates.

            Now here's where things get weird. In a normal world having a rising currency would be a good thing. In upside-down world, a rising currency is a sign that you're headed in the wrong direction. You see, in the current age of currency wars the idea is to sink to the bottom, not rise to the top. The weaker the currency, after all, the cheaper (and thus more attractive) your exports on the international market. So by this logic, Japan is winning the game hands down; the Yen has depreciated by over 22% in the last 6 months alone. This is why the ECB is now floating the negative deposit rate idea: they are artificially suppressing the Euro.

            Not only is the US losing, but the “masters” of America's economic universe—the owners of the privately-owned Federal Reserve—are working to keep the dollar even higher. As everyone knows by now, the currency war is all about quantitative easing (also known as “printing money like there's no tomorrow”), the modern form of which was spearheaded by Ben BernanQE over at the Fed. This has set off a global tide of easing culminating in the Japanese “Abenomics” phenomenon (more on which in a moment). But since markets are operating on the assumption that—despite the moniker “QE Infinity”—the Fed will have to ease off the printing press eventually, so the dollar is getting ready to rocket upward at the first whisper of the rumour that the easing is ending. So why is John Williams, the President of the San Fran Fed, spreading rumours that the Fed may completely end easing by the end of the year? Given that Williams does not have a voting position on the Federal Open Market Committee this year, there are two possibilities: he's speaking out of turn of his own free will or he's being used as an arms-length plausible deniability cutout to spread rumours around the markets. Either way, the dollar is rising and the markets are already getting ready to price in a reduction in the dollar supply...or more accurately a reduction in the rate of expansion of that supply. In an upside-down universe, that's about as good as an actual money supply contraction for shoring up a currency.

            Contrast the upward inclination of the dollar with the runaway yen. The yen stormed through the 100 USDJPY barrier and is upwards of 103 yen to the dollar as of press time. By their own standards, the Abe-era Kuroda-led Bank of Japan's foray into the realm of quantitative easing seems to be a runaway least on the surface. After all, the pledge to double Japan's monetary supply in the next two years has already resulted in near 5-year lows of the yen, a ridiculous surge in the Nikkei (up over 66% in just 6 months to break the 15,000 mark earlier this month), and even a first quarter GDP growth rate of 0.9%, which equates to 3.5% growth in annualized terms. That's a pretty remarkable turnaround for a hitherto moribund economy, but alas for the Japanese we are in upside-down world so these numbers do not reflect any improvement in the country's underlying fundamentals. The economic boost is about evenly divided between the placebo effect of the easing itself—which resulted in a 0.9% increase in domestic consumer demand—and the predictable effect of rising exports on the back of the sinking yen. More reliable drivers of growth, however, like capital spending, actually dropped over the quarter, which does not bode well for the future of this artificial easing surge.

            More worrying by far is the craziness unfolding in the JGB markets right now. Earlier this week Japanese government bond futures markets were halted twice in one night as prices plunged. 5-year yields surged at their highest rate in nearly 3 years and 10 year futures saw their biggest two-day sell off since the Lehman collapse. Interest rate volatility is skyrocketing and the obvious implication is that the BOJ does not have control over the quadrillion yen domestic bond market, which is the real cornerstone of the Japanese economy and the only thing allowing the government to maintain its astronomical debt-to-GDP ratio. As the IMF warned last year, JGB market volatility is one of the key macrofinancial risks for Japan, with BOJ estimates indicating a 100 basis point rise in market yields would lead to mark-market losses of 20 percent of Tier 1 regional bank capital. Given that Japan's banking sector is tenuous at the best of times, the knock on effects of runaway bond yields might just signal the dawn of the apocalypse in the land of the rising sun.

            Meanwhile, Spain is leading the way in another upside-down indicator: trade surplus. Once again in a regular universe a trade surplus would be a positive sign of a booming export economy. In upside-down world, though, Spain's trade surplus is a reflection of plummeting imports. There's no way to spin this into good news; imports plunged 15% as unemployment continues to hover around the 26.7% mark. Don't worry, though; Santander director Juan Rodriguez is assuring whoever's listening that Spain will bottom out this quarter and we'll see “green shoots” appearing in Q3. Someone better tell S&P and Fitch. They've already indicated that they may be ready to downgrade Spain's debt again. Given that they're only one level above junk after the October 2012 S&P downgrade, this is not an indicator of an economy on sure footing.

            Spain is by no means the only Eurozone country mired in recession, though. Earlier this week the bloc released its latest figures showing that the zone had extended its recession to the sixth straight quarter. The ECB cut interest rates by 0.5% earlier this month to a new record low in a vain attempt to boost growth, and now they're floating the idea of negative overnight deposit rates.

            The problem that all of these countries are going to have to face at some point, however, is that upside-down world is like a bubble of non-reality. And like any bubble, it will pop at some point, bringing the upside-down economic world back into contact with cold, hard economic reality. In other words, there will be a reckoning at some point. Whether that reckoning will kick off with a runaway Japanese bond market or an unexpected end of QE Infinity or a default in the Eurozone, there is no doubting that the entire economic house of cards is balanced on a knife edge. Happy investing!