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US Federal Reserve entering currency wars?

Janet Yellen’s dovish comments on Tuesday pushed the World stock indices to all-time highs, also pushing USD lower. Big buying was seen in Asia, as by Wednesday, the MSCI Asia ex-Japan index stood near a 5-month high. Also USD took a hit vs. Asian currencies dropping sharply for two consecutive days

Over the past few months (also mentioned in our previous article), central banks from around the world have acted to devalue their currencies; this includes the RBA, RBNZ, Riksbank and ECB, to name a few. More recently Sweden cut its repo rate to negative and showed intention to buy government bonds worth 10 billion SEK. RBNZ’s Wheeler also talked down NZD by suggesting that he would prefer to see it near 0.72 vs. the USD. It seems central banks are very happy to pick up the free stimulus that’s available to them by devaluing their currencies.

However, the main problem is that no amount of stimulus or currency devaluation can make a country competitive, and structural problems in Eurozone and Japan still pose a significant threat to the World economy. No wonder then those Central banks have been unreliable in increasing growth, and have started participating in the less than ideal approach of currency weakening; Fed has so far been a notable exception.

Of course, a currency war is a zero sum game, but as long as the Fed is willing to let the dollar appreciate (it acts as a tightening mechanism), or as long as US maintains its growth rate, other countries can profit from this added stimulus. But, the rising dollar is already posing problems for the Fed, as US companies are feeling the squeeze when exporting amid a rising USD. 

The Fed would therefore tread with caution when it comes to the first rate rise and may want to see a gradual USD appreciation (rather than a upward spiraling USD) over the next 12 months. Also the Fed is likely to keep a keen eye on growth in China and the Eurozone.  Hence the US Federal Reserve is unlikely to raise rates if it senses that the global growth is still fragile, even more so if it thinks that a rising USD will pose a threat to its own recovery.