USD: "Losing" the Currency War?

It’s been another incredible week for the world’s reserve currency, with the dollar index hitting a new 11-year high near 95.00. By now, we all know the catalyst for the latest dollar rally was yesterday’s announcement of a massive QE program from the European Central Bank, which had led to a 24-hour, 500-pip selloff in EURUSD at one point in today’s European session, though the pair has since stabilized in the 1.12s. The ECB’s action represents an escalation of a trend that’s quietly been gaining strength over the past few weeks: competitive devaluations by world policymakers, or in other words, a currency war.

For the uninitiated, a currency war is when countries intentionally enact policies to devalue their currency in an effort to stimulate economic growth. While these actions tend to weaken the overseas purchasing power of their residents, a startling number of countries have decided the risks are worth the reward over the past two weeks:

· The SNB cut interest rates to -0.75% last week (though that dovish move was overshadowed by its decision to drop the cap on the franc)

• Turkey, India, and Peru all cut interest rates last week
• The Danish Central Bank cut Denmark’s main interest rate twice to -0.35%
• The BOJ revised down its inflation expectations for 2015
• Both BOE hawks swung back to the dovish side of the ledger
• The BOC shocked traders by reducing Canada’s benchmark rate to 0.75%
• …and of course, the ECB embarked on the aforementioned QE program

In this latest skirmish in the global currency war, the losers are the countries that refused to play the game; in this case, that list is essentially limited to just the US. Though almost every other central bank across the world is easing, the Fed continues to obstinately insist it will raise interest rates later this year, so it’s not surprising that the dollar index has rallied an incredible 24 of the last 28 weeks on its way to a fresh 11-year high (see chart below).

So what’s the end game?

History shows that currency wars rarely work out well. In the worst historical cases, notably including the Great Depression, international trade and global economic eventually slow down, especially once the “big guns” like trade embargos and capital controls are brought out. While we’re optimistic that the current iteration of currency wars won’t deteriorate that far, the recent strength in the dollar could at least cause the Federal Reserve to put its rate hike ambitions on hold for now. The last thing the central bank wants at this point is to exacerbate the deflationary impact of a strong currency.

Source: Stockcharts.com and FOREX.com