The Currency Wars Look Real, and the Prospects Could Be Grim

How do you know you’re in a currency war?

Central banks will be cutting rates like it’s going out of fashion, for a start. Stephen Cohen, chief investment strategist for BlackRock international fixed income, noted that 15 central banks have already cut rates this year. And there could be more to come with the People’s Bank of China and the Bank of Japan expected to ease policy further.

The kind of currency volatility that creates "is something we expect to continue,” said Mr. Cohen.

Which brings us to exhibit B: foreign exchange volatility.

David Woo and Vadim Iaralov at Bank of America Merrill Lynch say realized FX volatility -- or the magnitude of swings -- right now has spiked to its highest non-crisis level for the past 20 years. According to their own proprietary FX volatility measure*, currencies have only been choppier during the Russia and Asian crises back in the late 1990s and in the aftermath of Lehman Brothers going bust in 2008.

“There is a growing consensus in the market that an unspoken currency war has broken out. For many countries facing zero interest rates and binding fiscal constraints, the only policy tool left at their disposal to stimulate growth is a weaker exchange rate,” the strategists noted.

This has serious consequences. Higher currency volatility will increase both the riskiness and the cost of cross-border transactions, whether it is trade in goods or capital flows.

BAML notes that higher FX volatility will raise the costs for companies hedging currency exposure, potentially having a “significant negative impact” on the profit margins of exporters.

This may lead companies to focus more on their home markets. In other words, a sustained period of FX volatility could dampen global trade growth. And it could discourage foreign direct investment flows, as well as reducing the appeal of carry trades for investors.

The conclusion is a bleak one: While a weak currency may give countries a short-term shot in the arm, these beggar-thy-neighbor policies fast become futile if everyone is doing the same thing.

“This in turn will likely exact a toll on global trade and capital flows,” said BAML.

*The BAML measure is a GDP-weighted range-based currency volatility index constructed for the 20 largest economies in the world, calculated as the difference between the maximum and minimum exchange rate in a 26-week rolling window.