Business & Finance Investing & Financial Markets

Trading Forex - are currency wars ahead?

On Thursday, March 12th, Swiss National Bank surprised investors by intervening to bring down the Swiss Franc. Over last year there was a lot of talk about just such action, but the expectation was on Bank of Japan, in light of massive Yen rally. Recently Japanese currency weakened somewhat, effectively ending any such talk. Thursday's development broadened the expectation on behalf of market participants for more of these steps.

This represented the first time a leading central bank has intervened in the foreign exchange markets since 2004, when the Bank of Japan sought to weaken the Yen. At that time effectiveness of these steps was questioned, since Yen failed to react in any meaningful way. This time results was clear. The speed and magnitude with which the Franc responded, dropping 3 per cent against the Euro in a matter of minutes, also shows that if a central bank wants its currency to fall, it can deliver.

Among reasons stated for intervention were sharp deterioration in Switzerland's economy, unacceptable appreciation of the Swiss Franc against the Euro and to address the threat of deflation. The last factor is something Swiss financial authorities are particularly afraid off. Intervention in Foreign exchange market was combined with cutting interest rates to 0.75% and announcing plans to adopt a quantitative easing approach to monetary policy through buying bonds.

While halting deflation was the official motive behind the move, some analysts are concerned the tactic would be considered as a move to bolster exports. This, in turn, might trigger devaluations from other central banks, effectively starting "currency wars".
With world in deep recession, nations could attempt to make themselves more competitive at the expense of everyone else. Cheaper currency is one of the tools towards this goal.

Countries relying on exports as a disproportionately large part of GDP might very well be tempted to follow Swiss lead. Japan and China are very likely candidates but not the only ones. China allowed its currency to appreciate about 26% on a trade-weighted basis over the past four years and has seen its exports tumble. While its difficult to discern how much of this can be attributed to currency appreciation and not global economic slowdown, exchange rate is high on a list of concern for Chinese officials.

Indeed, premier Wen Jiabao, already expressed concern about USD getting any weaker. As a largest lender to US, China would like to see the dollar to remain strong. This statement delivers a quiet warning on the eve of new borrowing campaign by Washington to fund next stimulus package: "Do not devalue the dollar or we will not lend you any more the money".

Actions by Switzerland might very well be justified. After all, its perceived "safe heaven" status contributed to a sharp Franc's appreciation, particularly against the Euro. This might have been too much too fast. Some devaluation of Swiss currency should also aid in stabilization of Eastern Europe's markets. Consumers there had indulged in the Swiss Franc carry trade, taking out mortgages denominated in Swiss Francs. Since last July, strong CHF gains made those mortgages unbearable. Things should calm down now to some degree.

At the moment it is difficult to say if other central banks will follow SNB example. Precedent has been set and with global economy sliding ever deeper into recession "currency wars" are a real possibility. Even if nobody else does it, threat of intervention will stay with the markets, adding to already high volatility. From trading perspective this is good news, since bigger moves provide possibilities of larger profits. Currencies should prove to be great trading instruments for the rest of the year.
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