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How does a Currency War Start?

By Louis Holding-Parsons on September 4, 2019

5 (100%) 1 vote[s]

A currency war is when a country manipulates its currency so as to gain an advantage, usually financial. Beijing has recently been accused of currency manipulation by the US Treasury. The USA feels the Yuan is being held artificially low in a form of pegged exchange rate. This has led to retaliation by the USA in the form of increases in trade tariffs on Chinese exports. Yet could it be that the USA is also attempting to manipulate its currency? 

New age economics: currency wars!

We are living in an extraordinary age of economics. Many of the theories that one studies at university, are now increasingly being used in day to day life. No one ever thought that quantative easing would ever be used to such an extent as it has today. Yet would we think that a currency war could take place? Forex news is full of statements about a brewing economic war between the USA and China.

Did you mention a glass ceiling…?

 USDCNY on the Weekly time frame showing the breakout as a result of the brewing currency war
Currency pairs have patterns and can often trade in a range for set periods of time. Occasionally this changes. The recent breaking of the 7 Yuan to the Dollar barrier may appear as just a new number, but what has caused it is interesting. It is clearly part of a developing currency war with the United States. The US feels the Yuan has not been allowed to increase in value as economics dictate it should. In retaliation the USA has imposed tariffs (increased tax) on Chinese exports. To negate these increased tariffs, Beijing has responded by devaluing its currency through the 7 Yuan to the Dollar barrier. Beijing’s strategy seems clear, if the USA hits us where it hurts (exports) it will hit you where it most hurts (currency).

All is not what it seems….

The Fed has been caught in the cross hairs of a developing currency warAlthough the US treasury has been quick to label China as a currency manipulator, it could be somewhat hypocritical of the USA to do so. Trump has regularly stated that he feels the US dollar is too strong. Originally markets paid attention to this rhetoric and adjusted accordingly, which could lead to currency manipulation accusations against Trump. Today markets pay little direct attention. Instead Trump has now launched repeated attacks on the US Federal reserves to reduce interest rates. Such blatant attempts to influence an independent institution such as the Fed, is driven by votes. Trump needs a strong US economy to ensure re-election. Lowering interest rates usually leads to more spending and therefore growth. 

The Fed’s prison sentence

The Fed will be forced to protect the US in a currency warThis has put the Fed somewhat in a tricky position. Central bankers through quantative easing have become the rock stars of finance. They are sometimes called the Chief Investment Officers of world stock markets, such is the power they wield through quantative easing. This new found prevalence makes it harder for them to withdraw from the limelight, especially when they are being ”called out” as Trump is making a habit of. Furthermore, the Fed as a central bank does not want to be seen to be influenced by the White House. It is clear that a developing trade war could affect the US economy and require action. Lowering interest rates would be one typical reaction and would likely lead the US dollar lower. In effect the Fed could be accused of trying to cheapen the US dollar as a response to the weakening of the Yuan…

To me to you…

So whose fault is it? The US or China’s? Depending on where you sit, your viewpoint is likely to be different. China has undoubtedly benefited from cheap labour and become a manufacturing powerhouse. Yet today it is facing increasing competition from Indochinese countries and a young workforce which does not want to work in factories. Its response is to become a consumerist society, i.e. sell its goods to itself. But this transition cannot happen overnight so it needs to remain competitive with exports. This explains why it is prepared to create a currency war with the USA through interventions in its currency.

Trump's rhetoric is unbearable for many and may lead to a currency warThe USA on the other hand has no qualms in taking action to protect its interests but will tend to be more subtle. It is clear though that some within the USA are conscious of the power they wield. The 2013 taper tantrum caught the Fed off guard and they have been conscious ever since not to cause instability and volatility with their actions. Unfortunately, they have a president in Trump who seems hellbent on exactly the opposite. The Fed may end up satisfying Trump’s dreams by lowering interest rates in response to poor economic data, pushing the US dollar lower! A cheaper US dollar will not be popular in Beijing, leading to a retaliation and a prospective currency war!

Conclusion

Trade wars and Forex are increasingly part of the economic landscape today. Currency wars are not just a possibility, they are already happening. At the heart is self interest, yet intriguingly, both participants are aware of their roles. The USA through the Fed and China as a key buyer of Western goods. This suggests that although retaliation has already taken place, it is likely ‘strong posturing’ and will not lead to an all out currency war which would be destructive for both USA and China. 

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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