Boiling Point: Currency Wars Take Center Stage

October 18, 2010

Global monetary policy is turning into a game of whack-a-mole between central banks, and a dangerous game at that.


It’s been over three years since the market stopped functioning smoothly, and central banks haven’t yet wound down their efforts at stimulating growth. Instead, they’re accelerating them, causing important correlations between currencies and stocks and bonds to break down, thus highlighting the need to own gold and stay liquid.

Chadd BennettAll this “quantitative easing”—QE as it’s called—that involves central banks buying their sovereign bonds with borrowed money, is devolving into a game of “whack-a-mole” or, worse yet, currency wars. As one central bank prints money, it puts more pressure on the next to print in order to offset the negative effects a strong currency has on exports.

Japan, Brazil and the eurozone are all growing alarmed at how strong their currencies have become and, as a result, the IMF is now studying the “spillover” of this central bank “race to debase” in what it calls its “systemic stability initiative.”

Whatever the IMF decides, I see two possible scenarios playing out that I’ll outline below. But where it all ends is anyone’s guess, which is why I think staying liquid and raising cash is important right now.

Shifting Correlations

The Bank of Japan’s (BoJ) problems with yen appreciation stand out especially. Since mid-2007, the Rydex CurrencyShares Japanese Yen ETF (NYSEArca: FXY) has rallied over 40 percent as the yen has surpassed its previous high in 1995 despite the BoJ’s recent intervention.

The chart below, showing the relationship between U.S. 10-year Treasury yields and the yen, tells the story. Notice how benchmark yields began moving opposite the yen starting in spring of 2007. While there have been brief periods like this before, it’s never been more pronounced than since 2007.

US 10-Yr Treasury Yields vs. Yen

(For a larger view, please click on the image above.)


One of reasons for this move is the overall deleveraging going on as everyone from individuals to corporations look to lighten their debt burdens. Another could be the simple fact that borrowing in yen to invest in Treasurys to capture the yield differential is no longer attractive. Some have even speculated that the dollar has replaced the yen as the currency of choice for the carry trade.

But what’s significant and clear is that whatever the cause, the forces causing this divergence in U.S. yields and yen strength is still in full force today.

To make matters worse, the historical correlation between the S&P 500 and the euro/yen cross has gone by the wayside since the fall of 2009, as the chart below shows.

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