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The Currency War is About to Escalate

Talk of an end to QE is gibberish...

JEEZ THIS is getting boring. Stocks go up on QE/stimulus hopes. Then, when stocks have the rare down day, it's on concerns QE/stimulus will end, writes Greg Canavan for the Daily Reckoning Australia.

What a farce this all is. QE will never end. It can't. Only the pace of its twisted and corrupt purchases will vary.

But a market hooked on the cracky odors of QE is no longer a rational beast...not that it has been in any way rational for many, many years now. So when the Federal Reserve's Charles Plosser says he favors scaling back the pace of stimulus, the market sells off in a panic.

It's pathetic really. An equity market is meant to be a predictor of the economy and business conditions six months hence. Now it's a daily punt on the utterings of fools masquerading as wise men.

No wonder capital is edgy. No wonder it's shifting to the core...the safety of global blue chips. If the Fed's starting to push everyone around, why not move where it's a bit safer...if only in a relative sense?

The other point to note about the edgy nature of global capital is that when it shifts to the core, it has an effect on currency markets too. If global blue chips are the core of the equity market...then the US Dollar is the core of the financial system.

The Aussie Dollar cracked overnight, falling nearly 2 cents against the greenback. It's nearing parity once again. We think, in time, it will go right back through that level to where it belongs...somewhere around the 80 US cent level.

Many people can't understand why or how the US Dollar could possibly be strong with the 'Bernank' monetizing US$85 billion per month. The simple fact is that the US is at the core of the US financial system. When the system is healthy, money flows from the core to the periphery.

So a weak or weakening US Dollar is bullish for the global economy...in that it's a sign of robust conditions elsewhere in the world. For example, when the US runs large trade deficits, it sucks in goods and services from around the world and pays in IOU's...usually in the form of US government bonds.

The Dollar denominated bonds then become the 'reserves' of the country that sent the goods and services to the US. That country can then expand its domestic credit on top of these increased reserves...which then increases economic activity. So the US gets a free lunch and exporters get seemingly unlimited demand for their products.  It's a sweet system.

But when it's not working too well, the US Dollar strengthens. Capital changes direction and goes from the periphery to the core. This happened in a heartbeat in the 2008 crisis...now, the process appears to be deceptively slow.

After all, global markets keep going up, masking the underlying fragilities of the financial system.

But the recent move back into the Dollar suggests an underlying caution taking place. Capital seeks a refuge in the 'city-state' stocks...companies with revenues larger than many nations' GDP. To buy many of those stocks you must buy the US Dollar first.

So as the US Dollar-centric system totters, paradoxically you'll see the US Dollar strengthen. All other currencies will fall by the wayside. We'll look back in a few years' time and laugh at the 2012 meme of the Aussie being a 'reserve currency'.

The final bout will take place between the Dollar and gold. Gold will win of course, but the Dollar will put up a fight. It will go the 12 rounds.

One of the chief reasons for this continued flight into the US Dollar is, we think, directly related to Japan. As you know, the Bank of Japan recently made an all-out assault against the Yen. The Japanese currency is now considerably weaker against its major trading partners.

There is no doubt yen weakness was behind the Bank of Korea's decision to cut interest rates yesterday by 25 basis points to 2.5%. Korea is a major competitor to Japan and is feeling the pinch of its currency moves.  Data released in April shows Korean export growth at just 0.4% year-on-year. Not good for a nation highly dependent on export growth.

The main front in the currency war has moved to Asia. Perhaps that's why the Australian Dollar fell so hard overnight. Currency and trade wars between our major commodity consumers do not bode well for the future.

And China is a major victim of the currency wars too. Owing to its loose peg to the US Dollar, China to some extent imports US monetary policy. So the Fed's $85 billion per month monetization program causes inflationary problems there.

Yesterday, China reported slightly higher than expected inflation figures for April, with annual prices rises of 2.4%. This puts policymakers in a bit of a bind. As Reuters reports:

'China's annual consumer inflation accelerated more than expected in April while factory prices fell for a 14th consecutive month, highlighting the dilemma facing the central bank as it balances support for the economy against the threat of rising prices.'

The link to the Dollar benefitted China for many years. It underwrote their industrialization and urbanization. But now it's becoming a problem, which is why China is looking increasingly to liberalize its financial markets and allow capital to flow more freely. 

But that won't be an easy task. Freeing up the capital market too soon could cause the banking system to crash (captive savings of the Chinese household sector have underpinned the country's historic credit boom). China will need to move very carefully.

And it will have to do this while dealing with a belligerent neighbor in Japan, who by devaluing the Yen is trying to steal from anyone whatever dwindling demand is out there.

So as the US Dollar moves above 100 Yen for the first time in four years, any talk about the end of QE, or even scaling it back in anything beyond words, is just more Fed gibberish. Get ready for an escalation in the currency wars.

Greg Canavan is editor and publisher of Sound Money, Sound Investments, a weekly financial report devoted to unearthing great value investments amid today's "money illusion" of fiat currency. Formerly editor of Australia's market-leading finance newsletter, Greg has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as LewRockwell.com and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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