Deflation fears to renew currency wars as ECB poised for QE, say analysts

Simon Watkins
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With global economic growth still stuttering, currency depreciation has become a zero-sum game for central banks, and recent developments in some key currencies have shown that fears of an inflation undershoot or outright deflation will remain an important driver for their currency policies.

Until global growth began to stutter, countries used to be comfortable with the notion that they might lose some of the available regional trade to a neighbour that was depreciating its currency because the world’s overall economic pie was growing, and their share net/net would still be growing as well.

In recent times, though, in a world of anaemic, if any, economic growth across the globe, currency depreciation by a neighbour makes this a seemingly zero-sum game, in which one neighbour’s currency depreciation means a neighbour empirically losing out on the available international trade and investment capital flows.

With the stakes so raised, central banks have had to use a much broader array of policies to ensure their countries come out on top, way over and above direct intervention in the FX markets that used to be the principal weapon of choice. These tactics are set to endure in this year’s currency wars as well.

As the scale of the US economic recovery remains uncertain, China’s growth trajectory looks negative from now on and there are questions about the nature of economic growth in the eurozone and Japan, the key focus for many of the world’s central banks in the coming months will be on inflation figures, says Carl Hammer, chief FX strategist for SEB in Stockholm.

He adds: “With inflation declining in many countries, fears of disinflation or of outright deflation are growing, and in that environment there is a general desire to avoid currency strength, as it would only increase deflationary pressures.”

In this respect, says Daragh Maher, currency strategist for HSBC in London, the European Central Bank's decision to cut rates on November 7 was based on the “latest indications of further diminishing underlying price pressures” which, as ECB president Mario Draghi explained, marked a change from his opening remarks at the previous month’s meeting when he described underlying price pressures as “expected to remain subdued”.

“In other words,” adds Maher, “the extent of the downside surprise in the October flash estimate (0.7% versus 1.1% expected) had a big impact on the decision and, given that the ECB usually emphasizes the medium-term inflation outlook, the focus on a single release was surprising.”

The decision was less surprising, though, given the mixed views of the markets on the eurozone’s current-account figures over the year, and these persist. Although on the surface the current account maintained a healthy looking surplus trend last year, which might argue for relatively high euro levels being acceptable to the ECB for the time being, a closer look beyond the headline numbers reveals the fragility of both the eurozone’s economy and its currency, says Manuel Oliveri, FX strategist for Crédit Agricole in London.

Oliveri says: “Rather than being a function of a boom in exports from the eurozone, the current account appears to be driven by a marked reduction in the level of imports, and demand in general from the area, which is a very different picture.”

Nor, indeed, does the relative strength of the euro look as if is a function of enduring capital inflows either, says Maher. It is true that in recent months there has been a particularly sharp acceleration in equity market holdings, largely since Draghi announced in mid-2012 his willingness to do “whatever it takes” to protect the euro project, but it is also the case that they still remain below the levels at the start of the crisis.

Consequently, Maher adds, regarding the relatively robust euro as a function of its improving current account and/or healthy capital flows is counter-intuitive for two reasons: first, there has been a more marked improvement in the US current-account balance than in the eurozone’s, and G10 FX performance has not been closely tied to deficit developments during the crisis; and, second, the source of improvement in the eurozone’s current-account balance has been much lower import demand.

Given the actual dearth of real demand in the eurozone, then, Hammer, among others, predicts that the ECB will begin a proper quantitative easing (QE) programme by the end of this first quarter; along the lines of the bond-purchasing US Federal Reserve model, rather than the “QE by any other name, Long-Term Refinancing Operation” that it used last year.

“We expect to see the ECB buying bonds from banks in the eurozone at the of the first quarter of this year in amounts significant enough to show that it is serious in underpinning growth across the region; and, of course, the change in intervention style will be significant for the markets as well."

Indeed, estimates currently for this bond-buying programme are for around EUR40 billion worth per month, to begin with.

The recent trading patterns of sterling have also been significantly affected by inflation numbers, adds Oliveri. In this respect, he says, it is true that in large part the rally in sterling in recent months has come from stronger than expected economic growth numbers, which have persuaded the market that the Bank of England’s (BoE) threshold for considering rate increases (7% or less unemployment) will be met earlier than the Bank had expected.

However, the sell-off after the fall in the core inflation rate in October was largely predicated on the view that the Bank of England would have more leeway on policy if inflation was holding back below its target level, thus underscoring the importance of inflation figures in the new currency war games.