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The Great Currency War & Financial Markets: Bracing for the Final Act

Historically, it has been difficult for a country to enjoy an equity bull market and exchange rate appreciation indefinitely, as testified by the experiences of Japan and the US. Corporate sector performance is eventually undermined whenever currency strength becomes excessive.

Contrary to expectations following the US Presidential Election, the dollar has depreciated on a trade-weighted basis during 2017. Meanwhile, US equities have benefitted from easier financial conditions, which are historically associated with a weakening US currency.

A weakening US currency does not always support an equity bull market, particularly if accompanied by rising bond yields due to unhinged inflationary expectations. Political pressure on Fed in 1987 produced the aforementioned scenario, resulting in a spectacular equity market crash in October.

There are similarities between the current environment and what prevailed in 1987 due to looming changes of personnel on the Fed’s Board of Governors. Bond investors will demand a higher term premium and raise short-term interest rate expectations if the Trump Administration leans on the Fed next year.

The world’s major central banks are struggling to achieve their inflation targets, particularly the Bank of Japan (BoJ) which has recently been forced to downwardly revise its consumer price forecasts. Governor Kuroda’s term expires next year and the legacy of his policy conduct will include the potential unsustainability of current asset purchase programmes.

Both the Fed and the European Central Bank (ECB) will be wary of permitting speedy currency appreciation, particularly the latter, due its effect of accentuating imported deflation. Yen depreciation remains the most convincing route to higher inflation in Japan, thereby implying that the race to bottom in the Great Currency War is not over.