Escalation of International Currency War Leaves Investors Wondering What’s Next.

What’s behind recent currency volatility? Who wins and who loses in today’s currency war? How strong can the U.S. dollar get before it’s detrimental to its growth? What’s next for the yuan? Three market experts analyze the health, wealth and manipulation of currencies around the globe

David Lafferty

Chief Market Strategist Natixis Global Asset Management

Currency volatility returns

In the second half of 2014, foreign exchange (FX) markets shifted as investors began to recognise the divergence between the U.S. Federal Reserve (Fed) and the European Central Bank (ECB). After a brief respite, China’s recent devaluation of the renminbi has put currency volatility back in the spotlight.

In a global economy with little organic growth, countries are looking for any way they can to boost economic activity. With fiscal and monetary measures all but tapped out, many policymakers are turning to currency to strengthen exports. In theory, a country that can manage its exchange rate lower should benefit from increased exports, as their goods become relatively cheaper in currency terms, and decreased imports, as their imports get relatively more expensive. This lift to net exports (exports minus imports) accrues as additional growth to the country.

While China had several reasons for devaluing its currency in August, the main reason was to support faltering exports as the country adjusts to its slower growth rate. To maintain export competitiveness with China, economies across Asia and other emerging markets had to reduce their FX values as well.

So who will win the currency wars?

Perhaps no one. Recent research from the World Bank has documented that currency devaluation doesn’t have the same export-boosting effects it once had1. Today, exports are more likely to be finished goods derived from imports in an earlier stage of the value chain. As a result, the price benefits of a lower FX rate on exports are somewhat (or mostly) offset by the cost increase of imports. The research highlighted Japan as an economy that had undergone significant foreign exchange devaluation with minimal improvement to net exports. Countries will continue to manage (manipulate?) their currencies to maximize economic growth, but there is no free lunch. Ultimately, the real winners are the countries and companies that produce goods and services most efficiently.

Portfolio implications

Diverging central bank policies, China’s slowdown, and a collapse in commodity prices suggest that currency volatility will be with us for a while. How may investors mitigate these risks? First, it isn’t certain that the U.S. dollar will continue to appreciate – at least not at the same pace. The U.S. Dollar Index rose 25%, peaking in March of this year – without a single rate hike from the Fed. While the dollar could continue to appreciate at the margin, much of the currency adjustment from future rate increases has already been priced into the market. Don’t assume that continued U.S. dollar strength is a foregone conclusion simply because the Fed will raise rates at some point.

Second, currency volatility creates another reason for investors to diversify assets outside of their local markets. When you diversify your stocks and bonds globally, you also diversify your currency exposure. Oftentimes, the movement of the currencies can smooth the ride.

Finally, investors should understand if and how their managed portfolios are hedged with respect to currency movements. Foreign stock and bond portfolios can be unhedged, partially hedged, or completely hedged. When currency volatility is low to moderate, FX exposure can actually diversify away some risk (see above). But when currency volatility spikes, investors could be blindsided by FX losses that can swamp the return of the underlying assets. For that reason, using managers with a well-designed hedging strategy may help you sleep better at night.

1. Ahmed S, M Appendino and M Ruta (2015). “Depreciations without Exports? Global Value Chains and the Exchange Rate Elasticity of Exports”, World Bank Policy Research Working Paper No. WPS7390, Washington, DC

Brian Hess

Global Markets Fixed Income Strategist, Full Discretion Team Loomis, Sayles & Company

The term “currency war” may sound like sensationalism. But the series of competitive devaluations in the currency markets over the past several years have essentially created a series of global currency battles. In fact, it was the U.S. who fired the first shot via the introduction of quantitative easing (QE) during the midst of the global financial crisis, followed by a reinforcing of the troops via “QE2” in 2010. At that time, there was an outcry of protest from the central banks of emerging markets (EM). They feared that a wave of capital flows was likely to be unleashed upon their economies as a side effect of QE2, and that such sharp inflows were likely to create:

  • misallocations of capital
  • excessive credit growth
  • asset price inflation
  • inflated currency values

The EM currency depreciation has, in many cases, led to imported inflation pressures, which in combination with weak growth due to diminished credit flows created stagflationary economic conditions. This has placed EM central bankers in an extraordinarily difficult bind. They cannot ease monetary policy to stimulate growth, as they normally would in such a situation, as easing policy would only make matters worse for them on the external vulnerability front. Nor can they afford to risk stoking inflationary pressures further. This unfavourable fundamental backdrop, currently characterising the economies of Brazil, Turkey and South Africa, tends to create a negative feedback loop. The loop begins with falling asset prices, leading to weaker growth, lower currency values, higher imported inflation, tighter monetary policy, and eventually weaker asset prices.

What could break the cycle?

The good news is that many EM currencies have become quite undervalued compared with long-term measures of fair value. This could help support their export competitiveness, despite declines in the currencies of other large export-oriented economies including Germany, Japan, and China, where currency depreciation has typically been less severe.

The other key variable is stronger global growth. Most emerging markets economies are dependent to some degree on external demand. Better global growth might lift animal spirits among investors and make them more willing and comfortable to invest in beleaguered EM economies that are badly in need of their capital. Our job as investors is to understand where true value exists in our universe and then begin to accumulate positions wherever we find it. That said, there appear to be pockets of value in emerging markets assets today. But for now they are still badly in need of a fundamental catalyst to help unlock the opportunity.

Brigitte Le Bris

Head of Emerging Markets and Currency Natixis Asset Management

Currency wars are not new to markets. In fact, the current cycle we are going through started with the U.S. Federal Reserve in November 2008 as a response to the Global Financial Crisis. This summer, the People’s Bank of China (PBOC) entered the game in earnest by lowering the level of its currency.

China has multiple objectives in mind: to adjust its foreign exchange (FX) level, which had dramatically increased, in order to boost exports and fight deflation. Primarily, however, its action was implemented to improve the internationalisation of the Chinese yuan (especially looking to gain Special Drawing Rights or SDR inclusion alongside the euro, Japanese yen, pound sterling, and U.S. dollar).

All of the monetary policy actions taken by the U.S. Fed, European Central Bank and Bank of Japan during the past few years appear to have worked. That’s because they were coherent with fundamentals and because FX interventions were also accompanied by monetary easing and fiscal spending measures. During that time, almost no central bank (with the exception of Bank of Switzerland) that suffered indirectly from these measures tried to curb depreciation or appreciation of its currency and go against the market by using its FX reserves, for example. This summer, Asian currencies were caught by the downwards adjustment of the Chinese yuan but no developed nation’s central bank reacted. That’s simply because the adjustment was fair and very much in line with weaker economic fundamentals in China.

Are there any winners and losers?

Much of the currency interventions by emerging market countries this summer were relatively well justified. One exception would be the Mexican peso, which is often used as a proxy to other emerging market currencies and therefore has a tendency to amplify the moves. Emerging market foreign exchange (EMFX) is under pressure and will probably remain that way until we witness signs of better economic growth. On the opposite side, the G3 currencies should remain well supported. Of course, the Fed decision not to hike interest rates in September brought some relief. But it also brought uncertainty, which has slightly weakened the U.S. dollar. As long as the U.S. remains the best oriented economy in the world, the greenback should remain strong. Furthermore, should the U.S. dollar become so strong at some point that it starts to derail U.S. corporate earnings and U.S. trade balance, the markets should be efficient enough to adjust it to weaker levels.


Animal Spirits a term used by John Maynard Keynes used in one of his economics books. In his 1936 publication, "The General Theory of Employment, Interest and Money," the term "animal spirits" is used to describe human emotion that drives consumer confidence. According to Keynes, animal spirits also generate human trust.

G3 refers to the world's three leading economic blocs – the U.S., Japan and the European Union.

Special drawing rights (SDR) are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund (IMF). Their value is based on a basket of key international currencies reviewed by IMF every five years.

European Central Bank (ECB) is the central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed in Germany in June 1998 and works with the other national banks of each of the EU members to formulate monetary policy that helps maintain price stability in the European Union.

People’s Bank of China (PBOC) is the central bank responsible for the monetary system of China and the yuan currency.

Quantitative easing (QE and QE2) refers to monetary policy used by a central bank to stimulate an economy when standard monetary policy has become ineffective – such as the U.S. Federal Reserve Bank enacted after the Financial Crisis of 2008–2009.

Stagflation is a condition of slow economic growth and relatively high unemployment, a time of stagnation, accompanied by a rise in prices, or inflation.

Volatility is the degree of variation of a trading price series over time.

Yuan refers to China’s currency.

The World Bank is an international organisation dedicated to providing financing, advice and research to developing nations to aid their economic advancement.

Published in November 2015

The affiliated investment managers and distribution companies are each an affiliate of Natixis Global Asset Management, S.A. Although Natixis Global Asset Management believes the information provided in this material to be reliable, it does not guarantee the accuracy, adequacy or completeness of such information. • This material should not be considered a solicitation to buy or an offer to sell any product or service to any person in any jurisdiction where such activity would be unlawful.

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This communication is for information only and is intended for investment service providers or other Professional Clients. The analyses and opinions referenced herein represent the subjective views of the author as referenced unless stated otherwise and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material.

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