February 21, 2013 | By Scott Minerd
It appears as though the yen and the dollar will continue to fall relative to the euro for the time being. Although pursuing higher GDP growth through currency depreciation can have short-term benefits, such policy efforts rarely end without negative consequences. This is especially true when nearly all of the world’s major economies engage in such a race to the bottom. The buildup of pressure in the foreign exchange markets may evolve into a major issue for investors later in the year.
This is not the first time we have been through a period of currency market-induced volatility. As a result of the Plaza Accord of 1986, the dollar depreciated for nearly 21 consecutive months. This trend only ended when the Louvre Accord of 1987 attempted to stabilize currency markets by halting the dollar’s descent. During the period the dollar was plummeting, the U.S. economy roared and the stock market boomed. In time, however, the potential collapse of the dollar became an increasing concern, and inflation pressures mounted as input prices rose. In the second half of 1987, the Federal Reserve attempted to stave off further erosion of the dollar’s value by raising interest rates several times, which led to the stock market crash in October of that year. The scenario facing us today may evolve differently, but the net effect, namely higher volatility and upward pressure for asset prices in countries pursuing growth via devaluation, will likely be the same.
Mark Carney, the incoming Governor for the Bank of England, has signaled his willingness to tolerate a higher inflation rate in exchange for faster economic growth. In anticipation of more aggressive monetary stimulus and potential inflationary concerns, investors are selling pounds and buying inflation-linked bonds. As a result, the British pound has depreciated sharply, while inflation expectations have risen. Since the start of the year, the pound sterling has fallen 6.3% against the U.S. dollar, and the U.K. five-year expected inflation rate has surged 80 basis points.
Source: Bloomberg, Guggenheim Investments. Data as of 2/20/2013. *Note: The U.K. five-year inflation expectation is implied by the difference between five-year inflation-linked government bond yields and five-year nominal government bond yields.
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