Beggar-my-neighbour policies

There seems to be an increasing sense of uncertainty developing on how the US Federal Reserve will manage policy over the next six months. The narrative emerging is that the Fed have backed themselves into a corner on a rate hike, something that is creating unease among investors. The reality is that there will never be a right time to raise rates, but they may have to proceed with a rate hike to stave off another financial asset bubble, if we’re not already in one.

A further complication is that in the face of other central banks easing policy, the Fed may be forced to postpone rate hikes and consider more QE, to roll the dice again on the risk of a financial asset bubble in favour of what they believe is support for the economy. If such a scenario plays out, long term US government bond yields could be headed significantly lower.

As countries are effectively competing for less global economic demand, monetary policy is a competitive tool to weaken your currency and boost your economy at the expense of your neighbouring countries. Of course, your neighbours don’t just sit idly by and watch, they react with the same policies. This is what we’re seeing today with the so-called currency wars. This has never ended well.

How long will the Chinese sit by and watch everyone else devalue their currency? The argument against a Yuan devaluation or a dollar peg adjustment is China’s ambition to make the Yuan a reserve currency. However, with economic growth and inflation falling faster than expected, such a move won’t be off the table.

To learn more on currency wars, I suggest you read the most recent quarterly report (only 5 pages!) from Hoisington Asset Management, an investment firm in the US who tend to provide some thought provoking research. The report gives a useful historical context for where we are today in terms of the high levels of indebtedness which is constraining economic growth and fostering beggar-my-neighbour policies from the world’s central banks.