A Giant Game of Currency Chess

No matter how bad things get this week, just be thankful you’re not the Greek finance minister. Vassilios Rapanos resigned his post four days after being appointed. He’d been in the hospital after collapsing on June 22nd, probably after getting his first look at the real state of Greek finances.

Greece will be one of the items on the agenda at this week’s European Union summit. The coalition led by new Greek President Antonis Samaras pledged to renegotiate the terms of the previous bailout deal between Greece and the EU. That was the $163 billion deal.

As if that wasn’t enough uncertainty for the EU, Spain has formally requested a $125 billion bailout for its banks. Cyprus joined the bailout queue overnight, too. Bloomberg reports that the island nation needs around $5 billion to recapitalise its banks after losses taken on Greek government bonds. Fittingly, Cyprus will assume the rotating Presidency of the EU on July 1st.

The whole crisis is proceeding as expected. Marginal institutions at the periphery get locked out of the credit markets. Money flees to the core of the financial system. Anyone at the margin, or exposed to it, is left in no man’s land.

In 2007, the firms at the periphery were US subprime lenders. Surprisingly, it turned out that emerging market stocks were at the periphery too. That’s a risk for Australia this time around. The risk is that emerging markets get smashed again. No one is going to sit around and debate whether the Chinas and Indias of the world can thrive without Europe. Money will walk while everyone else talks.

The institutions at the periphery today are governments that can’t bailout their own banking systems without help from the outside. The problem is acute in Europe because the 17 countries that use the euro currency don’t have the option of printing money or unilaterally devaluing the currency to inflate away the debt and/or increase export competitiveness.

The Currency Battle and the Fed

But all that is a bunch of blah, blah, blah. Let’s think about today’s currency events as moves in a war, or a giant game of currency chess, if you will. Let’s assume the US Federal Reserve is playing its own game: lower short and long-term interest rates in order to keep 30-year mortgage rates low (allow refinancing of outstanding mortgages at lower rates) and especially in order to allow the Federal government to finance $1.5 trillion annual deficits as US households and businesses deleverage.

Good for you Fed. Well played. But the trouble is, the Fed effectively runs the rest of the world’s monetary policy. The rest of the world is on the US dollar standard. Low US rates mean everyone else has to competitively devalue (lower rates) to retain the established order. The dollar is, as ex-US Treasury Secretary once said, ‘our currency but your problem.’

It’s a problem now for Europe. And for China. The Fed’s quantitative easing gambit has put the rest of the world’s currency players in the position of Zugzwang, where any move results in a weaker position. In chess, you’re in Zugzwang when you must make a move that damages your overall position. Europe is in Zugzwang now.

Any move to strengthen the fiscal union results in political weakness. Any move to allow weak banks to fail results in a weaker Union and a weaker currency. In game theory, the Europeans are losing the game. So who is winning?

Well, so far you’d have to say the Fed. But don’t count out the Chinese just yet. The dollar peg has forced the Chinese to match US monetary policy. The result, until recently, was a property bubble. The Chinese know they need to get off the dollar system. More on that tomorrow.

Where the Aussie Dollar Currency Could Head

For Australia, other than idiotic government regulation, the biggest risk is that the Aussie dollar becomes a casualty in the currency war. The Aussie could fall by as much as 30%, according to Andy Xie, the ex-Morgan Stanley chief economist for Asia Pacific. Xie reckons falling commodity prices and declining foreign investment have set up the Aussie for a 2008-style fall.

If he’s right, that fall is likely to be accompanied by a 2008-style fall in Aussie stocks as well. You can’t have lower commodity prices and foreign investment AND higher resource stock prices, can you? This would be the market confirmation of the basic idea that the commodity boom — at least in its current form — is over.

That would be big news, wouldn’t it? Yet our own technical analyst Murray Dawes is setting up for just that kind of news. He reckons there could be two big moves in 2012…a huge one down (which you’ll want to miss) and then a big rally (which you might be able to trade, if you can avoid the initial wipe-out. Murray’s ‘Big Wednesday’ forecast goes live later today. You can have a sneak peek now.


Dan Denning
for Markets and Money

From the Archives…

The US Deficit of Deceit
2012-06-22 – Greg Canavan

How Nice to Have Friends At the Fed
2012-06-21 – Bill Bonner

Deep in the Stock Market Trenches
2012-06-20 – Murray Dawes

In Praise of the Eureka Rebellion
2012-06-19 – Dan Denning

What Could Possibly Go Wrong With Infrastructure Investment Bonds?
2012-06-18 – Dan Denning

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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