Buttonwood

Low interest rates and sluggish growth may lead to currency wars

Declaring trade peace might be the best way to get a cheaper dollar




IN 2010, AS the euro zone’s sovereign-debt crisis escalated, the euro fell sharply, from $1.45 to $1.19. Soon the talk in America was of a second round of quantitative easing by the Federal Reserve. Was this a coincidence? Many in euro land thought not. QE2, as it came to be known, seemed to them to be mostly a means to a weaker dollar. The grumbles went beyond Europe. That September Guido Mantega, Brazil’s finance minister, said his country was under fire in an international currency war.

Now the bellyaching comes from America. On June 18th Mario Draghi, the president of the European Central Bank (ECB), said at a conference in Sintra, Portugal, that the bank stood ready to relax its monetary policy further if the euro-zone economy did not improve. Bond yields fell. So did the euro. President Donald Trump took to Twitter to denounce Mr Draghi for “unfair” currency manipulation. Earlier this month Steven Mnuchin, Mr Trump’s Treasury secretary, had fired a warning shot in the direction of Beijing on currency policy. If China stopped trying to support the yuan, he seemed to suggest, that could be understood as an effort to weaken it.

The guns have been holstered again. The prospect of a pow-wow between Mr Trump and Xi Jinping, China’s president, at a G20 summit in Osaka later this month has raised hopes that, at the very least, the trade war between their two countries does not escalate. A trade truce ought to cool the war of words over exchange rates, too—but not for long. Interest rates are low. The use of fiscal policy is constrained by either politics or debt burdens. A cheaper currency is one of the few ways left to gin up an economy. A world of sluggish GDP growth is one that is primed for a currency war.





Despite Mr Draghi’s best efforts, the exchange rate to watch is dollar-yuan, not euro-dollar.

The yuan increasingly sets the tone for global currencies—and, by extension, for financial markets. China has allowed its currency to respond somewhat to market pressures since August 2015. But it has been kept in a fairly tight trading range against the dollar (see chart).

These small changes matter. The currencies of China’s big trading partners, such as the euro, have got caught up in the yuan’s shifting tides, rising and falling in sympathy. Seven yuan to the dollar has been seen as an important threshold. Should the yuan ever breach that level, it would surely drag other currencies down with it.

Any hints that Beijing may be prepared to let the yuan go beyond seven are thus significant. Simon Derrick of BNY Mellon points to two developments in this regard. The first is the publication in late May of a seemingly well-sourced article in the South China Morning Post on trade negotiations with America. A sticking point, it said, was the yuan. China favours currency “flexibility”—not for an export advantage but to ensure stability. America is unsympathetic. Then, on June 7th, the governor of China’s central bank, Yi Gang, told Bloomberg that a flexible currency was to be desired as it “provides an automatic stabiliser for the economy”. He also hinted that there was no red line at seven.

There is a topsy-turvy logic to currency wars. The winners are the currencies that fall in value. In such a race to the bottom, investors seek to back the losers. In times of trouble they will go for the usual boltholes: the yen, the Swiss franc and gold, all of which have been lifted by trade-war anxiety. The dollar stays strong because America has high interest rates, by rich-world standards, and a strong economy. But when growth slows and interest rates fall, says Kit Juckes of Société Générale, a French bank, other factors come into play. These include trade balances and valuation.

The yen stands out. Japan runs a current-account surplus. And the yen is cheap based on measures of purchasing-power parity, including rough-and-ready gauges, such as The Economist’s Big Mac Index. The Swiss franc is also backed by a hefty current-account surplus, even if it looks expensive. Gold gets a look-in mainly because there are so few good alternatives to holding dollars.

In 2010 the cheap dollar irked everyone outside America. Now the dear dollar bothers America, or at least its president. In the slow-brewing currency war, America is both victim and perpetrator. “If you start a trade war with your biggest trading partners, they get a weak currency and you get a strong one,” says Mr Juckes. If Mr Trump wants a cheaper dollar, declaring trade peace might be the best way to get it. Otherwise, America risks waging a currency war on itself.

Business finds itself left out of the party

Politicians will see few votes in backing corporate America until its priorities change

Andrew Edgecliffe-Johnson



Which tribe of politicians can claim to be the party of business? Back in the tax-cutting, deregulating, privatising days of Ronald Reagan and Margaret Thatcher, the question was simple to answer on each side of the Atlantic. But Donald Trump and Brexit have a way of scrambling well-worn assumptions.

British executives are pondering the prospect, in Boris Johnson, of a Conservative prime minister who dismissed their Brexit concerns with the words “fuck business”. Their US peers are hearing the same message, less explicitly, from Republicans.

President Trump was not the corporate establishment’s candidate in 2016, but business has found much to thank him for as he responded to its complaints about taxes and regulations in familiar Republican fashion. Boardrooms can even put a number on that gratitude: US corporate tax payments fell 31 per cent last year, while profits hit new records, due to Mr Trump’s late 2017 tax cuts.

Chief executives have also cheered the reliably deregulatory rhetoric emanating from the White House after eight years of tighter Democratic regulation in the wake of the financial crisis.

There has been one big break from past partisan certainties: Mr Trump’s trade war with China. In the past week, the Business Roundtable has blamed ratcheting tariffs for a fifth straight quarter of declining CEO confidence; Walmart and Levi Strauss joined 600 companies in saying that they imperil 2m US jobs; and the US Chamber of Commerce warned that they could cost the US $1tn in the next decade.

As executives lose hope that the Trump administration will achieve the immigration and infrastructure reforms they seek, relations are fraying. So, too, is business support for Republicans. “CEOs are abandoning the Republican party in droves,” wrote Alan Murray, CEO of Fortune, after a recent survey by the magazine found that fewer than half the people running the country’s largest companies now identify as Republican. Yet the number calling themselves Democrats remains “minuscule”, he noted, because as Mr Trump’s GOP cedes the “party of business” mantle, Democrats show no sign of looking to seize it.

Democrats have always seen the case for talking tough about business, especially at the early stage of presidential contests when union endorsements can be critical. But there is a difference in degree this time as candidates across the crowded Democratic field vow to rein in corporate power.

Both Joe Biden and Bernie Sanders have berated Amazon for its low tax bill, while Kamala Harris, Pete Buttigieg and other Democrats have joined striking fast-food workers who are campaigning for McDonald’s to raise its minimum wage to $15 an hour.

Mary Kay Henry, president of the Service Employees International Union which told Democrats they must back the “Fight for $15” pickets to win its support, says that candidates are “responding more boldly” to its pressure this election.

“Presidential candidates have to speak to the growing inequality in the economy,” she argues, adding that calling out companies for paying low wages “speaks to the gut feeling that most working Americans have that the rules are rigged against us”.

There are still 500 unpredictable days left in the election campaign. But when Democrats argue for a more assertive antitrust policy, rail against share buybacks or promise — in Elizabeth Warren’s words — “economic patriotism”, it is clear they see these talking points as vote winners beyond their party’s base. Polls suggest they are right, and that should wake business leaders up.

Executives may despair of Washington’s attitudes, but they need to remember that voters (who are also consumers and employees) are closer to the politicians than to the CEOs in their beliefs about proper corporate priorities.

According to surveys by Just Capital, a non-profit funded by the investor Paul Tudor Jones, Americans of all stripes rank a company’s treatment of its employees, customers and community far above the returns it makes for shareholders: like Mr Trump and Ms Warren, they believe that US companies should focus above all on creating well-paid jobs in America.

Profound ideological differences remain between the parties, of course, not least on taxes and the environment. If the Democrats choose one of their most leftwing 2020 contenders as their candidate, it would undoubtedly scare many donors back to Mr Trump’s party.

But on offshoring, wages and jobs there is increasing common ground. Any company that has not found an answer to Mr Trump’s America First rhetoric will not find the task any easier if the pressure is rebranded economic patriotism by a Democrat.

With politicians less willing to speak up for them, US business leaders will have to make their case on trade, tax and regulation more directly. But this will ring hollow unless they can show they are sharing the prosperity they believe capitalism brings with the people they employ.

Until then, it will be easier for politicians to say “fuck business” than to be caught in bed with the corporate elite.

Now That’s Just Crazy, Part 1: Junk Bonds With Negative Yields

by John Rubino


A central bank that’s desperately trying to ignite a borrowing/spending frenzy to offset an incipient recession has one wish above all: That the currency it’s creating flows beyond safe-haven assets and into riskier niches. Call it the democratization of credit or Ponzi finance. Either way, the result is a lot of borrowing and spending, which solves the immediate slow-growth problem.

So it must come as a pleasant surprise for monetary authorities that a growing number of “high-yield” bonds are trading with negative yields. You read that right: some junk bonds now yield less than nothing.

So far, this is happening mainly happening in Europe, where the ECB has been soaking up the bonds of junk countries like Italy, producing Italian government bond yields comparable to those of the US and not far from Germany’s. Now some of this torrent of newly-created euros is flowing into the corporate equivalent of Italy, sending the share of one-step-above-junk BBB rated bonds with negative yields to double-digits. Meanwhile, the share of actual junk bonds with negative yields is above zero and rising fast.

junk bonds negative yields


For the entire universe of European BB-rated bonds (to repeat, these are junk), the average yield is now comparable to what the US pays on 10-year Treasury bonds.

junk bonds negative yields



So why is this happening, and is it as bad as it seems?

The short version of “why” is that when a country borrows too much money, its rising debt slows future growth unacceptably, leading politicians to bully central banks into cutting interest rates further and buying up more assets. Eventually, this process reaches its logical conclusion, which is zero-to-negative interest rates and central bank balance sheets stuffed with assets of laughably low quality. Which is where Europe now finds itself.

And still, the politicians demand more. So rates go negative across the high-quality yield curve (German 10-year paper now yields -.30%), forcing everyone who needs income to move into junkier assets. And voila, high-yield starts trading like Treasuries.
 


As for why that’s bad, well, let’s count the ways. First, it funnels cheap capital into companies that by definition don’t deserve it, which results in “malinvestment” on a vast scale. Second, it starves pension funds and retirees that need income, forcing them to take on ever-higher degrees of risk.

Combine massive misallocation of capital with excessive risk-taking by investors who don’t understand risk, and the result is an epic crash when junk borrower cash flows inevitably disappoint.

Why do investors put up with it? Saturday’s Wall Street Journal offers a chilling explanation:
One euro junk bond from U.S. packaging company Ball Corp, for example, trades at a yield of minus 0.2% and matures in December 2020. That compares to a European deposit rate of minus 0.4% or a yield on a German government bond with a similar maturity of about minus 0.7%. 
The choice for investors is about the balance between needing to stay invested and how much risk to take, according to Tim Winstone, a fixed-income portfolio manager at Janus Henderson. A bond like Ball Corp’s is “a safe place to hang out,” Mr. Winstone said. “And just because something is negative-yielding, that doesn’t mean it can’t get more negative-yielding.” Falling yields mean rising bond prices and gains for investors, at least on paper. 
Many expect more bond yields to go negative as central banks in the U.S. and Europe cut interest rates or return to bond-buying to stimulate economies. In Europe especially, investors are realizing that negative interest rates are going to last a long time because the ECB needs to overshoot its inflation target to make up for the long spell when inflation has been far below 2%. Without a period of higher inflation, it won’t meet its target on average over the medium term. 
The number of junk-rated companies with negative-yielding bonds will definitely go up, according to Barnaby Martin, credit strategist at Bank of America Merrill Lynch. “It doesn’t take much for it to go from 14 companies to 30 or 50 or 100,” he said.

In other words, investors are now extrapolating falling interest rates into the future and playing junk bonds for the capital gains they’ll generate when their future borrowing costs go down. This is one of those sentiment shifts that financial historians will single out for special attention when sifting through the rubble of the coming crash.


Hating the Fed Is as American as Apple Pie

The tone of Trump’s attacks is new even if the sentiment isn’t. But try living without a central bank.

By Justin Lahart


The tension between Fed Chairman Jerome Powell and President Trump has ample precedents, starting with differences between Treasury Secretary Alexander Hamilton, who proposed the first U.S. central bank, and then-Congressman James Madison, who disliked the concept. Photo: Photo Illustration by Emil Lendof/The Wall Street Journal; Photos: Getty Images


When President Trump complains about the Federal Reserve, he’s taking part in a tradition of central-bank bashing that stretches back to America’s founding. But for all the missteps the Fed has made over the years, the country is better off with it than it would be without it.

Mr. Trump has made no secret of his disdain for its policies. During his election campaign he said the central bank’s stance was too easy, fueling “a big, fat, ugly bubble.” Now he argues the Fed raised rates by too much last year, and has repeatedly called for it to cut them. On Tuesday he suggested he could consider demoting Fed Chairman Jerome Powell.

Mr. Trump is publicly criticizing the Fed in a way no U.S. president has before. But he is also tapping into a longstanding animus toward central banking in the U.S., the power of which shouldn’t be discounted. Investors who take the Fed and the independence it has achieved for granted may need to brush up on their history.

That history begins in 1790, when Treasury Secretary Alexander Hamilton submitted his proposal for the Bank of the United States. Modeled after the Bank of England, it would provide loans to the public and private sectors, and the notes it issued would provide a uniform paper money for business transactions.

Virginia Rep. James Madison and Secretary of State Thomas Jefferson tried to block Mr. Hamilton’s plan, saying it was unconstitutional for the government to set up a bank. Their opposition also arose in part from the prevailing attitude of the agricultural South and of farmers, who tend to be debtors and often detest banks. It was a populist theme that would be repeated.

President George Washington sided with Mr. Hamilton, and the bank was chartered in 1791. But antibank forces continued to pound away, and its charter was allowed to expire in 1811. After five rocky years for the economy, the Second Bank of the United States was chartered with then-President Madison’s support. But two decades later, that charter wasn’t renewed, squelched by President Andrew Jackson.

Starting in 1836, the U.S. stood out as a major country without a central bank. “And then we had a period characterized by financial instability and a much worse track record than any of the European economies,” explains Michael Bordo, an economic historian at Rutgers University. Booms and busts came rapidly, and a series of crippling financial crises culminated in the panic of 1907, the severity of which was a powerful argument for a central bank. Against stiff opposition, the Federal Reserve was set up in 1913.

The years since have, with some notable exceptions, been better. The economy swung far less erratically than before, experiencing far fewer financial crises. And as the Fed has gained more independence, insulating it from politicians’ desire to juice the economy ahead of elections, it has become a more credible steward of the economy.

But when the Fed slips up, or when times get rough, America’s old animus for central banks isn’t far away. The worst it got in recent memory was probably in the early 1980s, when the Fed under Chairman Paul Volcker tightened policy massively to crush inflation, buckling the economy in the process. Now he is widely hailed, but at the time he was getting attacked by both the right and the left. Unhappy home builders sent him two-by-fours pleading for lower rates, even as President Ronald Reagan largely held his tongue.

A board mailed to Fed Chairman Paul Volcker as part of a protest by builders over high interest rates, on display in the 2013 exhibition "The Fed at 100" at the Museum of American Finance in New York. Photo: STAN HONDA/AFP/Getty Images


The 2008 financial crisis also did heavy and justified damage to the Fed’s credibility, since it horribly misjudged the risks that built up during the housing bubble. The unconventional policies it subsequently adopted to combat the recession were also viewed as a massive overreach by critics who were convinced the Fed put the economy at risk of currency debasement and inflation.

Other countries celebrate their central banks: For its 300th anniversary in 1968, Sweden’s Riksbank established the Nobel Prize in economics, and the Bank of England’s tricentennial in 1994 culminated with a service of thanksgiving attended by the Queen. The Fed initially wanted to make an event of its centenary in 2013 but wisely opted for a quiet affair.

Mr. Trump can find sympathy beyond his populist base for threatening the Fed’s independence—after all, it expresses a sentiment that has spanned the political spectrum. Even some financially sophisticated people who should know better wouldn’t mind. They should know better.

Fiscal Money Can Make or Break the Euro

The parallel payment system that Greece's government proposed in 2015 would have bolstered the eurozone. By contrast, the Italian government's planned "mini-Treasury bills" would lead to the single currency's demise.

Yanis Varoufakis

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ATHENS – It’s a curious feeling to watch your plan being deployed to do the opposite of what you intended. And that’s the feeling I’ve had since learning that Italy’s government is planning a variant of the fiscal money that I proposed for Greece in 2015.

My idea was to establish a tax-backed digital payment system to create fiscal space in eurozone countries that needed it, like Greece and Italy. The Italian plan, by contrast, would use a parallel payment system to break up the eurozone.

Under my proposal, each tax file number, belonging to individuals or firms, would be automatically provided with a Treasury Account (TA) and a PIN number with which to transfer funds from one TA to another, or back to the state.

One way TAs would be credited was by paying arrears into them. Taxpayers owed money by the state could opt for part or all of those arrears to be paid into their TA immediately, instead of waiting for months to be paid normally. That way, multiple arrears could be eliminated at once, thus liberating liquidity across the economy.

For example, suppose Company A is owed €1 million ($1.1 million) by the state, while owing €30,000 to an employee and another €500,000 to Company B. Suppose also that the employee and Company B owe, respectively, €10,000 and €200,000 in taxes to the state. If the €1 million is credited by the state to Company A’s TA, and Company A pays the employee and Company B via the system, the latter will be able to settle their tax arrears. At least €740,000 in arrears will have been eliminated in one fell swoop.

Individuals or firms could also acquire TA credits by purchasing them directly, via web-banking, from the state. The state would make it worth their while by offering buyers significant tax discounts (a €1 credit purchased today could extinguish taxes of, say, €1.10 a year from now). In essence, a new dis-intermediated (middlemen-free) public debt market would emerge, allowing the state to borrow small, medium, and large sums from the private sector in exchange for tax discounts.

When I first discussed the idea, staunch defenders of the status quo immediately challenged the legality of the proposed system, arguing that it violated the treaties establishing the euro as the sole legal tender. Expert advice that I had received, however, indicated that the system passed legal muster. A eurozone member state’s treasury has the authority to issue debt instruments at will, and to accept them in lieu of taxes. It is also perfectly legal for private entities to trade among themselves in any token they choose (say, frequent flier miles). The line of illegality would be crossed only if the government compelled vendors to accept the digital credits as payment – something I never intended.

An altogether different reaction to my proposal came from those who wanted to end the euro as a single currency, but not necessarily as a common currency. A former chief economist of a major European bank looked at my proposals and recognized in them his own scheme for a parallel currency that Italy, Greece, and other distressed eurozone members would use to pay salaries and pensions. I replied that a parallel currency was both undesirable and pointless, as it would lead to a sharp devaluation of the new national currency, in which most people would be paid, while private and public debts would remain euro-denominated. That would be a recipe for serial, accelerating insolvencies, inevitably leading to the eurozone’s demise.

Then there were those who argued that an announcement of any parallel payment system would trigger a bank run and capital flight, thus pushing the country surreptitiously out of the eurozone, regardless of its intentions. This conjecture contains an important truth: the payment system I proposed would reduce the costs of a euro exit by clearing a rocky but navigable path to a new national currency.

Indeed, if my parallel, euro-denominated system had been operational in June 2015, when the European Central Bank closed down Greece’s banks to blackmail its people and government into accepting the third bailout loan, two outcomes would have been possible. First, transactions would have shifted massively from the banking system to our TA-based public payment system, thus reducing substantially the ECB’s leverage. Second, it would be common knowledge that, at the push of a button, the government could convert the new euro-denominated payment system into a new currency.

Would such a system have triggered a redenomination from the euro to the drachma? Or would it have given pause to the troika of Greece’s lenders (the European Commission, the International Monetary Fund, and the ECB), causing them to think twice before they closed down Greece’s banks and issued their Grexit threats?

The answer depends on the politics of both sides. In this sense, the parallel payment system is neutral: it can be used to bolster the eurozone just as effectively as it can be deployed to break it up.

In our case, the idea was to keep Greece viably within the eurozone by using the additional bargaining power afforded by the parallel payment system to negotiate the deep debt restructuring needed to revive economic growth and ensure long-term fiscal sustainability. As long as our creditors saw that our redenomination costs were lowered, while our demands for debt restructuring were sensible, they would think twice before threatening us with Grexit. Joint action by the ECB and my ministry would allow the parallel system to be portrayed as a new pillar of the euro, thus quashing any financial panic. By ending the popular association of the euro with permanent stagnation, the parallel system would be the single currency’s friend.

This brings us to Italy. There are two technical differences between the system I designed and Italy’s planned mini-Treasury bills (or mini-BOTs). First, mini-BOTs will be printed on paper, something I opposed, to avoid a grey market. Our total supply of digital credits would have been managed by a distributed ledger, to ensure full transparency and prevent the inflationary overproduction of credits. Second, the mini-BOTs will be interest-free, perpetual bonds, without future tax discounts.

But the real difference between the Italian scheme and mine remains political. The parallel payment system I proposed was designed to use the reality of lower eurozone exit costs to create new fiscal space and help civilize the monetary union in the process. Italy’s system is the first step toward a parallel currency by which to bring about the eurozone’s end.


Yanis Varoufakis, a former finance minister of Greece, is Professor of Economics at the University of Athens.