A currency war is coming

Frankfurt (Apr 29)  While most investors like to believe that things like earnings and the economic data drive the market’s ups and downs, lately it’s been all about moves in the currency market.

Since stocks started surging higher in late 2012, they’ve been marching in lockstep with the Japanese yen. Specifically, whenever the yen goes down, stocks rise. And when the yen strengthens, stocks weaken. (The relationship is so close that since the beginning of 2013, the yen’s movement explains 60% of the changes in the S&P 500.)

But now, amid some signs of stalling in the global economy and turmoil in the stock market (with the Nasdaq threatening its 200-day moving average for the first time since 2012), the currency market assumptions that have pushed the market higher over the last three years are under threat.

We’re on the cusp of an outright currency war — something that the Brazilians first warned about in 2010 — as central banks in all the major economies actively work to weaken their currencies to boost exports, their economies, and keep pushing inflation higher.

While headlines remain focused on the simmering conflict in Ukraine, the real battle is about to break out in the foreign-exchange market as countries battle, not for supremacy, but in a race to the bottom.

What has changed is that both China and Europe are quickly moving to weaken their currencies in an effort to support growth.

China’s actions have already attracted the ire of the U.S. Treasury, which in a recent semi-annual currency-market report singled out China as keeping its currency significantly undervalued after “unprecedented” decline earlier this year.

And in a first, the European Central Bank, after watching the euro zone’s overall inflation rate drop dangerously low amid stagnant credit creation, is now openly discussing launching a quantitative-easing bond-buying stimulus.

In a preview of the potential market turmoil that could be unleashed by ECB action to weaken the euro against the yen, just remember what happened on April 4 when stocks suffered an epic midday reversal from all-time highs on reports in the German press that ECB analysts were beginning computer simulations on what the impact of a bond-buying stimulus would be on inflation and growth.

The euro dropped hard against the yen, which drifted higher.