Posted By:  Matthias Paul Kuhlmey

After having pointed to political interventions into the foreign exchange system in yesterday’s update, “The Next Big Theme Revisited,” massive adjustments took place over night, leading the values of the Japanese Yen (JPY) and the Swiss Franc (CHF) lower. Over the course of 24 hours, market participants could witness the Swiss National Bank lower interest rates to close to zero, while at the same time providing better CHF-refinancing options for domestic banks. The Bank of Japan, on the other hand, sold JPY against the USD to lower the Japanese Yen from close to its post-war high of USD/JPY 76.25.

Last year, we had given a series of lectures on Currency Wars (see for example: http://www.hightoweradvisors.com/pdfs/Market_View_MK_Executive_Summary_ABFE_Speech_11_22_2010.pdf), and it is clear that, with last night’s price movements, the world has entered into a new phase of an already “brewing conflict.” Currency Wars are not a new concept. In 1931, the U.K. was the first country that realized that it could improve its competitiveness by devaluing the Pound Sterling against Gold (competitive devaluation).

Beyond several peripheral conflicts, the dispute of the most prominent Sovereign Currency War is taking stage between the U.S. and China, now the world’s second largest economy. At the center stage of this dispute is China’s strategy to continue pegging its currency, the Renminbi (RMB), to a basket of major currencies (before 2005, RMB was pegged to the USD exclusively). Much of the trans-Atlantic controversy has been about the resulting misaligned RMB exchange rate, as well as the need to correct related trade and financial imbalances between China and its major export markets, particularly the U.S.

In contrast to the above situation, the distinguishing characteristic of a floating exchange rate system, which is mainly the standard today, is that the price of a currency adjusts automatically to whatever level is required to equate the supply of, and demand for, that currency. On this basis, the demand for a given currency reflects the behavior of a nation’s exports and capital inflow, while the supply of that given currency reflects the behavior of a nation’s imports and capital outflow.

It is suggested that an artificially low currency, with above in mind, will help a country to gain competitiveness in export markets. On this basis, U.S. lawmakers have blamed China for lost jobs in America. Already last September, as the U.S. has not been effective over the years in pursuing China to establish a fair exchange rate mechanism/policy, the U.S. House passed a bill that could penalize Chinese goods, in an effort to coerce China to let its currency rise faster.

China, on the other hand, traces the root causes of the current crisis, as well as the related global imbalances and exchange rate challenges, to the dismantling of the Bretton Woods Dollar-Gold system in the early 1970s, and the transition to a “U.S. Dollar System” that came after the August 1971 Nixon shock, when former U.S. President Nixon’s declaration of the New Economic Policy of the United States suspended the convertibility of officially held dollar liabilities into Gold.

The aforementioned is typically an entry point for applying a framework of tariffs on imported goods, which may then lead to protectionism between countries and economies. In conclusion, we come back to yesterday’s recommendation: invest in currencies that are not considered currencies today, assets that are not flawed by political interventions.