This week we got the usual run of ambiguous economic data and a no-action Fed meeting. Nobody expected the Fed to raise its rate, so all is ho-hum.
But — not ho-hum. Not at all. On the surface, in plain sight, a very big story, but too technical for normal media, and so either ignored altogether or published garble.
I should know better, but … here we go: After several years of working against each other, global central banks are cornered, forced to work in concert against every historical instinct.
“Working against each other” has been a multi-year period of currency war. As structural economic weakness overtook both Europe and Japan, both the European Central Bank and Bank Of Japan bought time by weakening their currencies. Both also hoped that in the time bought, progress could be made against structural trouble. Too bad: no progress at all.
China has been the most unpredictable (more later) because its structural trouble is unique. Both Europe and Japan are sclerotic, while China is still in a youthful and wild expansion, but one which must shift from directed investment to market openness.
China, for a couple of decades, undervalued the yuan, but the adjustment ahead means that it is now overvalued, and the People’s Bank Of China is struggling for stability.
Meanwhile, the Fed has been moving in a completely different direction: The U.S. enjoys an actual self-sustaining expansion with future inflation risk, and needs to reduce Fed stimulus in anticipation of the day it must end altogether.
The global blood vessels are “banks” (financial institutions of all kinds), but the blood itself is national currencies. Currencies are in a constant state of relative movement, with value only in relationship to other currencies. The most basic value is the economic productivity of the culture issuing the currency.
But in the short term (“short” in currencies may be a decade), currency values shift because of interest-rate and inflation differentials, occasionally capital flight for safety (to or from), all temporarily distorted (for good or ill) by central banks.
Back to earth, briefly: the January upset in international markets, among other things leading to U.S. mortgage rates with in an inch of the all-time record low, was entirely due to a repricing of global growth prospects (down) and central bank reaction.
Back to currencies. If your central bank cuts its rate in relation to local growth and/or inflation, your currency will fall. And vice-verse. Today’s print-version Wall Street Journal blares this unfortunate headline “Global Currencies Soar, Defying Central Bankers.”
If you’re nervous about your understanding of currencies, you’re ahead of the WSJ, whose headline is dead wrong. Non-dollar currencies rose in value this week because the Fed dramatically backed down from its future tightening intentions. It had been in a hawkish argument with markets for years, and at long last this week admitted that markets have been correct — and did so not because of tame inflation here, but in spite of some up-signs. The Fed backed off explicitly because to tighten quickly would add to dollar strength and threaten to destabilize the world.
If the Fed kept on previous track — four hikes this year, and next, and next — the euro and yen might continue to weaken, emerging currencies certainly would — all a modest benefit. But, China pegs the yuan to the dollar. If the dollar rose more versus all of the others, so would the yuan, forcing a devaluation and adding to China capital flight.
Central bankers talk with each other, in communications as secret as nuclear hot-lines. They try not to surprise each other, and do what they can for each other. Yellen and her control group have clearly chosen external stability over inflation risk here.
Which likely ends the period of currency war, and also time-buying for structural reform, leaving economies to their own real selves. China is in the worst shape of all because it is attempting simultaneous control of its currency, its internal monetary policy, and capita flows. Only two of three are feasible by any nation.
Despite the boost from the Fed this week, China will fail, and the resulting global drag will keep rates here low, inflation low, and here … really pretty good!
Ten-year US T-note is stabilizing, more than half of the January drop retained. Ugly events overseas will bring a new drop, and only an authentic rise in inflation risk here will push rates up, accelerating the Fed’s tightening plans. Chart is 12 months back.
The 2-year US note is the Fed-predictor, the sea-change at the Fed evident in this week’s trading. The Fed’s meeting broke at 2 p.m. EDT.
The “damned little dots” in the Fed’s Summary Economic projections. Each dot is the forecast for the Fed funds rate at the end of each year ahead, by a Fed governor or regional bank president.
The highest five dots are the votes by five intellectually crippled but insuppressible regional presidents, who are certain that inflation is the greatest risk all of the time. This scattergram dropped a half-percent along its whole length since the last one in December.
There is an uptick in inflation measures, but I suspect — hope — it’s a temporary aberration.
Lou Barnes is a mortgage broker based in Boulder, Colorado. He can be reached at lbarnes@pmglending.com.
