Currency Wars in a Post 2008 World

Forex is one of the financial markets that have been most affected by the mean reversion effect in the last few years. The reason for this are the so called ‘’currency wars’’ initiated in the aftermath of the 2008 financial crisis. As economies around the world took a dive, governments tried to apply old mercantile policies to temporarily prop up economic statistics, at least until the next election.

With no easy solutions at hand, policy makers decided that the best way to give a quick boost to GDP stats is by a sizeable devaluation of their currency. The weaker currency makes the local goods cheaper to buy for foreigners thereby increasing exports. Because exports are added to the plus side in the Gross Domestic Product (GDP) equation, an increase in exports will translate into a gain for GDP. The reverse is also true, as imports are considered a negative for a country’s economy, a jump in imports will result in a lower GDP figure.

This economic view of the world contrasts with many scholars of the Austrian School who see consumption as the ultimate goal of any economic activity. The ultimate goal of a functioning economy is not to export but to import. To use another analogy on the personal level, people don’t work because they want to work, they work because they want to get the stuff that come from working. This is not to say that Austrians approve of large trade deficits. In fact, many see the current large trade deficits of the US economy as a sign that it’s not competitive in a globalised world.

After the financial crisis of 2008 the US Federal Reserve was one of the first to fire the shot in the ‘’currency wars’’. The Fed slashed interest rates in the lead up to the crisis from 5.75% to 2.25%. After Autumn 2008, rates were reduced further to zero. With nowhere to go, the central bank then embarked on an unprecedented quantitative easing campaign that saw its balance sheet go up several fold. Holdings of US Treasuries increased from around 800 Billion at the start of 2008 to over 2 Trillion. Mortgage-backed securities went up from 0 to over 1.2 Trillion USD. The chart below shows this massive balance sheet expansion. Treasury Notes holdings are marked with blue while Mortgage-Backed Securities are shown with a the red line.

Image taken from Wikipedia. 1) The direct consequence of the massive easing cycle was a global weakening of the US Dollar. The Federal Reserve started quantitative easing in March of 2009. By the end of the year, the Greenback lost 15% against the Euro in 2009 alone. The EUR/USD rose from 1.2631 to close the year at 1.4329. Against the Pound, the US currency lost 13% and closed 2009 at 1.6134. The USD/JPY was quoted at 97.73 on March 1. On December 31st, the currency pair traded at 93.12. The Japanese Yen gained against the USD for the next 3 years until it hit the 75.56 low in October 2011.

Japanese ''fight back''

The next installment in the currency wars involves the Japanese reaction to the US easing cycle. The March 2011 Earthquake and Tsunami disaster lead to a government decision to close all nuclear reactors in the country as a safety precaution until more comprehensive tests could be performed. Japanese energy companies now had to import expensive fossil fuels to make up the gap left by the nuclear plants closure. The decision singlehandedly reversed the longstanding Japanese trade surplus into a deficit. A devaluation of the Yen was starting to look like a very good option for some Japanese officials. The current Japanese Prime Minister, Shinzo Abe, won a landslide victory in the December 2012 general elections on a campaign focused on what was later termed ‘’Abenomics’’

Abenomics includes the following policies: inflation targeting at 2% annually, quantitative easing, expansion of public ‘’investment’’ and a correction of the ‘’excessive yen appreciation.’’ The Yen started to depreciate even before Abe got into office as the marker started to discount the anticipated effect of his policies. The Bank of Japan’s launch of QE in the spring of 2013 was only a formality and an official confirmation. The chart below shows the Dollar’s rebound versus the Japanese currency in 2013.

The USD/JPY traded at 82.37 at the start of December 2012. By March 1st 2013, the currency pair had gained to 95.95. The BOJ decision intensified the losses and by the end of the year the Dollar/Yen traded up to 104.84.

Systems that benefit from mean reversion

In conclusion, the mean reversion effect refers to the seesaw effect in currency markets like the one described above in the USD/JPY. One government weakens its currency in a bid to raise exports. The lower currency puts pressure on the other foreign governments by exporters to ‘’act’’. The foreign government responds by devaluing its own currency leading to a reversal in the exchange rate. With a multitude of central banks following the US Federal Reserve down the easing path post-2008, most of the major currency pairs have been trading with no clear direction. Strategies that benefit the most from this mean reversion effect are range trading systems. Trend following techniques tends to perform poorly when the market is stuck in this mode. Regarding indicators, oscillators like the Relative Strength Index (RSI) and the Stochastic Oscillator will do better than Moving Averages during stages of mean reversion.

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