Will the latest currency war pay off?

The eyes of Mr. Market were very much focused away from sterling assets last week. Central bank moves in 2015 have been extreme, and last week was no exception. The decision of the European Central Bank to launch a stimulus package worth a minimum of EUR1.1trn garnered all the headlines, but an unexpected cut in interest rates by the Bank of Canada was a lot more surprising.

There is no doubt that the Canadian economy has been hit hard by the fall in oil prices but nobody can seriously believe that a 25bps cut in interest rates is going to be enough to reverse the economic decline in the short-term. If the Bank of Canada was looking for a lower Canadian dollar then they got their wish; USDCAD has hit the highest level since April 2009.

Are these policy changes a symptom of more and more central banks joining a currency war? A great many nations have engaged in the practice of competitive devaluation of their currency to try and kick-start growth by boosting their exports.

It’s questionable whether this practice has ever really worked effectively. Before the 19th century, huge amounts of trade between countries were rare and therefore relative exchange rates were not much of an issue. Devaluation did occur but mainly via reducing the amount of gold and silver used within the actual tokens of money in the economy.

With the advent of global trade, exchange rates became more relevant and then came the Great Depression. Countries devalued their currencies within quick succession of each other in order to try and gain an advantage. No such advantage was really gained by anyone and following a collapse in global trade, the world moved into the Bretton Woods system of semi-fixed rates until the 1970s exactly to prevent this kind of thing from happening again.

Following the breakdown of Bretton Woods in 1971, most major currencies have once again become free floating and therefore susceptible to a competitive devaluation. In a world that is seeing widespread fears over deflation and low growth, is it really that surprising to see central banks resort to these beggar thy neighbour tactics?

Sterling benefited from these policies through the Bank of England’s quantitative easing plan launched in 2009. The value of the pound remained weak and the UK economy recovered, eventually, from 2011 onward.

Such are the moves in policy circles at the moment that last week’s Bank of England minutes had some people talking about further rate cuts from the Old Lady of Threadneedle Street in the coming months.

These minutes showed that Messrs Weale and McCafferty – who had previously voted for a 25bps increase in interest rates since August 2014 – had re-joined the pack and so the Bank of England is back to unanimity on the need to keep rates as they are.

While we have to wait until next month’s Quarterly Inflation Report to see what the Bank of England is truly thinking about inflation, it has become clear that there is a “roughly equal chance” that inflation could dip below the zero level within Q1. It seems that the Bank of England does not seem as prepared to look through these falls in headline inflation as the Federal Reserve, for example, and is therefore happy to lean on the prospects of further falls in wage demands to justify a loose monetary policy. At the moment, however, higher real wages – currently running at 0.8% – are helping the overall UK economy but are doing little to suggest that rate rises are coming anytime this year.

Sterling has had a rough couple of months against the US dollar, falling 11% against the greenback in the past six months. On a trade weighted basis, however, the pound is only down 1% -mainly courtesy of a 6.8% increase in the value of the pound against the euro. Trade weighted pound is quite strong at the moment but a move to weaken the pound by the Bank of England looks far away for now.