Who’s winning the Currency Wars?

BY SUPPLIED - MARCH 10, 2015

The European Central Bank (ECB) confirmed last week that it will begin buying government bonds on Monday, but the anticipation of the quantitative easing (QE) programme already had a big impact on the euro. The euro weakened by 20% from $1.39/€ in April last year, to below $1.10/€ last week. At the same time, the anticipation of QE has led to plunging bond yields and lower borrowing costs (for those willing and able to borrow). In fact, around a third of European government bonds now trade at negative yields.

The ECB expects inflation to average zero in 2015, before rising to 1.8% by 2017. Eurozone headline inflation was negative for a third month in a row in February at -0.3%. However, encouragingly for the ECB, market-based expectations for future inflation have picked up from very low levels. Eurozone equity markets are also pricing in better days ahead and had the strongest start to the year since the launch of the single currency in 1999 (the Euro Stoxx index is up 15% year-to-date in euros). The ECB will not necessarily admit it, but a weaker euro plays a big part in the way QE helps the Eurozone economy. (In a world starved of demand, a weak currency is a way to ‘import’ demand from other currencies.) Low oil prices also helped, with retail sales rising 3.7% year-on-year in January. The ECB has further upgraded its growth forecasts. It expects economic growth of 1.5% this year rising to 2.1% in 2017. These forecasts incorporate the impact of the €60billion a month QE programme running until September next year.  


Abenomics
has seen the yen plunge

Japanese policymakers have been more explicit about the need for a weak yen to revive growth and inflation. ‘Abenomics’ has succeeded in weakening the yen from ¥80/$ to ¥119/$ over the past four years. This has given Japanese company profits and share prices a boost, but the impact on the broader economy has been limited, partly because deflation has become entrenched, and also because of the April 2014 tax hike derailing the incipient recovery.

 
The mighty dollar rises

Meanwhile, the relative strength of the US economy, the smaller fiscal and trade deficits, and most importantly, the anticipation of rising interest rates, have seen the dollar rally. Even at 2%, the US 10-year Treasury is offering a high yield compared to Europe or Japan. While inflation is still below the Federal Reserve’s 2% target, and wage growth very slow despite falling unemployment, the first interest rate hike since June 2006 is on its way. On a real trade-weighted basis (in other words, looking at the currencies of the main trading partners and the differences in their inflation rates), the dollar is now at a 12-year high. In an era of floating currencies since 1973, the dollar had two major bull markets (excluding the brief surge during the 2008 financial crisis). This is the third. Partly because of their habit to borrow in dollars, the previous two bull markets (early 1980s and late 1990s) wreaked havoc among emerging markets (According to the Reserve Bank, South Africa has $62billion in foreign currency denominated debt, a relatively small amount). Whether the dollar strengthens much further or not is the proverbial million dollar question. The market is already pricing in higher interest rates and where the dollar goes from here will depend on the extent to which they materialise.   

 
Slower growth ahead for China

China is the original currency warrior. The yuan/US dollar exchange rate is fixed, but at a relatively weak level. Beijing has allowed it to gradually appreciate since 2005. But being pegged to the dollar, it has surged along with the greenback against other currencies. This complicates the picture for an economy traditionally reliant on exports. Chinese Premier Li announced last week that China’s growth target will now be “around” 7%, down from the previous 7.5% target. In practice, it means actual growth rates will probably be lower. This could weigh further on commodity currencies, some of which still seem overvalued. Australia’s real trade-weighted exchange rate is still historically strong, but has weakened in recent months. Slower growth in China might force the authorities to weaken the yuan, a policy it abandoned some years ago. Meanwhile, the Chinese central bank has cut interest rates again, with more probably on the way.

 
Sterling could strengthen further

The pound has reclaimed all the ground lost against the euro since 2007, closing at €1.38 on Thursday. Partly because of the benefit of a weak pound over the past seven years, the UK economy has outperformed that of the Eurozone. On a real trade-weighted basis, the pound is now in line with its historic average and has scope to strengthen further.

 
What does it mean for the rand?

The local currency weakened further to above R12/$ last week, a fresh 13-year low. The rand has hovered against the pound at around R18/£ for the last 12 months, also at an 11-year high. However, the rand has strengthened from an all-time low of R15/€ against the euro in February last year to around R13/€. These divergent trends reiterate the fact that global factors drive currencies. The rand therefore remains vulnerable to further gains of the dollar and the pound, but could strengthen further against the euro. Also weighing on the rand has been the fact that our current account deficit remains stubbornly wide, despite the large depreciation since 2011. Even though the real trade-weighted rand is historically weak, it might well be that the rand is still too strong to close the deficit. However, the fact that yields in South Africa are comparatively high means that there should be some support from yield-seeking foreign investors. 

 

Chart 1: US and South African real trade-weighted exchange rates

 

Local manufacturing slumps as global economy picks up speed

The local Kagiso manufacturing purchasing managers’ index (PMI) fell by 6.6 index points to 47.6 in February, from January’s surprisingly strong level of 54.2. A reading below 50 index points implies the sector is contracting. The two biggest subcomponents of the PMI were both below 50 points in February. The business activity sub-index fell 16.2 points, while the new sales orders sub-index fell below 50 for the first time since September 2014.

The PMI leading indicator, the ratio of new orders to inventories, picked up in February, but remains below one. This suggests that firms have sufficient levels of stock to meet orders and don’t need to increase production.


Local firms still positive about the future

Though lower than in January, the sub-index measuring expected business conditions in six months’ time remained quite strong at 64.4. This suggests that the big declines in other sub-indices captured the impact of load-shedding, which was particularly severe in February, and is expected to ease up later in the year.

A reason for optimism about the local factory sector is that global activity has picked up momentum. The JPMorgan Global Manufacturing PMI rose to a six-month high of 52 in February. If global activity continues to expand, South African firms should be able to capitalise, especially with the benefit of a weak rand. The frequency and extent of future load-shedding will be a big determinant of whether local manufacturing can improve.


Labour
disruptions knocked US manufacturing

The US ISM index was slightly lower in February, but at 52.9 index points, it was positive for the 26th consecutive month. Part of the reason for the weaker reading was a labour dispute affecting the five biggest ports on the West Coast, leading to severe congestion and delays (proving that it is not only in South Africa where strikes are causing disruption).

China’s official PMI inched up to 49.9, while the HSBC PMI, which focuses on smaller privately owned firms, rose to 50.1. While Chinese economic data from January and February are often volatile due to the shifting Lunar New Year holiday, these indices point to continued sluggishness. Since most of China’s exports to the US go through the same West Coast ports, the labour disputes there might have impacted Chinese firms.


Europe still modestly positive

The Markit Eurozone manufacturing PMI held steady from January’s 51 index points. Growth remains modest, but at least positive. In terms of individual countries, Ireland is experiencing a manufacturing boom after several years in the doldrums. Germany improved modestly from January. Italy and Spain – the number three and four economies in the Eurozone – saw slower growth in February. France, the second largest Eurozone economy, saw its manufacturing sector contract in February. 

 

Chart 2: Global manufacturing purchasing managers’ indices

 

 

 

Photo caption: Izak Odendaal, Investment Analyst at Old Mutual Wealth