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The quantitative easing programs that are being implemented by most central banks throughout the developed world have many good intentions, mainly to support the shaky economic situation. Nevertheless, as we all know, even the road to hell is paved with good intentions…one of the most noticeable unintended consequences of these very loose monetary policies is the creation of an ongoing currency war.

A currency war basically means that each country is trying to obtain a more competitive stand by devaluing its currency in an attempt to increase the value of its exports. This could potentially have negative consequences for investors and could lead to geopolitical conflicts.

This article is aiming to assist investors in better understand the currency war effects, how they should respond to it and hopefully benefit out of it.

No More "Unanimous Fed"

The FOMC (Federal Open Market Committee) oversees the trading desk in New York that buys US Treasuries and mortgage backed securities on behalf of the Federal Reserve. In the latest meeting, Fed leaders decided to take the unique action of purchasing $85 billion in bonds each month until 2014.

In the FOMC minutes Esther George, who heads the Kansas City Federal Reserve Bank, was the loudest but definitely not the only Fed member expressing a dissenting opinion which caused a sell-off in the market. George is concerned that the massive monthly bond buying could spark a currency war and have a negative impact on stability of the global financial market.

Admittedly, George's cause for concern appears to be reasonable. We are already witnessing a sizeable effect in the world's currency markets and this is to be intensified.

Looking at the Fed's protocols it's clear that a "new language" is being used:

§ SEVERAL FOMC PARTICIPANTS SAID EASING MAY PROMPT EXCESSIVE RISK

§ SEVERAL ON FOMC SAID FED SHOULD BE PREPARED TO VARY PACE OF QE

§ Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred

§ …but several others expressed concern about the potential for excessive risk-taking and adverse consequences for financial stability. Some participants mentioned the potential for a sharp increase in longer-term interest rates to adversely affect financial stability and indicated their interest in further work on this topic

§ Many participants also expressed some concerns about potential costs and risks arising from further asset purchases

The Underlying Environment and Causes of a Currency War

The current interest rate environment has created an arbitrage model for traders. Essentially, profits can be made by selling short a developed country bond, and buying an emerging market bond.

Developed countries, like the US, Japan, the eurozone, and the UK, have more or less guaranteed low short-term interest rates for the long-run. The central banks have communicated that these cheap fixed money rates extend to 2014 or 2015. To a savvy bond trader, the cheap short-term money can be borrowed, leveraged up, and then used to buy high interest rate paying bonds from an emerging market government or corporation.

The larger the spread of the interest rates, the better the return. The better the return, the faster the hot portfolio money flows into the currency that the high interest rate bond is priced in. The net result is that while developed countries currencies are depreciating those of emerging markets are appreciating.

For example, consider a trader that borrows from Japan's banks with a low interest rate of less than 1%. The trader then goes to a Brazilian bank and asks to convert the Japanese Yen (JPY) into a Brazilian Real (BRL), and uses the money to buy Brazilian bonds, real estate or stocks.

Over time and if done excessively, these flows of money ensure growing tensions and rising conflicts amongst the "winning" and "losing" countries. The end result of the above-mentioned example would be an inflow of capital into the Brazilian banking system causing the Brazilian real to appreciate. The appreciation of the real will cause Brazil's exports to be relatively more expensive and Brazil's exports to plummet. Correspondingly, Brazil's GDP growth falls as well. As such, it's safe to say that while the Bank of Japan is very happy with the result, i.e. depreciating JPY, the central bank of Brasil would be extremely dissatisfied with it.

Trillions of dollars are currently allocated in positions that pose a major risk to investors. Much like technology stocks in 2000, or real estate in 2008, these investments have the potential to severely affect the return of your portfolio, as measured by the respective valuation currency you're using.

On the other hand, the shift in currency rates is beneficial for developed countries, like the US, as it depreciates the dollar and improves export prices. Developed countries exports become cheaper in this scenario.

In a currency war, the exports of developed countries become cheaper while the exports of emerging market countries become more expensive. This causes geopolitical conflicts to rise as exports by developed countries increase at the expense of emerging market exports. Unfortunately, a currency war is a zero sum game.

It is important to remember that many emerging market nations, such as Brazil, have huge income inequality issues. Their leaders need strong GDP growth to deal with their citizens and to pay for their burgeoning social programs.

In other words, the artificially low interest rates created by the quantitative easing programs in the US and Japan erode the developing world's social gains. This causes internal conflict in the emerging markets which could include China, India, and South Africa.

Implications of Currency War on Asset Allocation

From an asset allocation point of view a currency war has dual-contradicting effects: On one hand, it creates a competitive advantage for developed over emerging markets. On the other hand, it's weakening the currencies of developed countries. The net effect of a currency war is therefore unclear.

The best solution, in my humble opinion, is to buy assets of developed countries while hedging the currency exposures of most developed countries. In more simple words, while buying assets of corporations that are based in the US, the EZ, the UK (long EWU) or Japan (long EWJ, though personally I rather stay away from Japanese equities) it's worthwhile selling the USD (long UDN or short UUP), EUR (short FXE), GBP (short FXB) or JPY (short FXY) against emerging markets currencies such as the BRL (Brazil), INR (India, long INR), MXN (Mexico, long FXM), RUB (Russia, long FXRU), TRY (Turkey) etc.

Don't get confused with ETFs that invest in emerging markets economies and not necessarily hedging against the currency exposure. Investing in Brazil (long EWZ), India (long IFN), Mexico (long EWW, MXE, MXF), Russia (long ERUS, RSX, RBL) or Turkey (long TUR, TKF or TUSC) may be a great investment but it's not necessarily addressing the currency exposure issue. There's a major difference between investing in a country's economy and a country's currency!

Until Quantitative Easing Ends…

Despite the recent dissenting voices, Mr. Bernanke - the Fed Chairman - has made it clear that quantitative easing will continue until we see a strong positive change towards the US economic thresholds. We don't foresee that landscape changing for at least a year or two, possibly even more. With sequestration occurring, and fourth quarter GDP coming in at an anemic level, we don't expect quantitative easing to end until 2014.

Keep these broad numbers in mind:

US GDP growth for 2013 is expected to be 1.5%, taking into consideration the sequestrations effects

Japan GDP growth is expected to be +1%; doubtful, as always…

Europe GDP is expected to be -0.5%, at best.

These very poor growth numbers will keep the quantitative easing programs in place.

At the end of the day, currency effects from low interest rates should be a positive for US exports and the US economy. There is still a great deal of opportunity in international investments, but it is important not to over-allocate internationally despite a depreciating dollar. If you are afraid of the US Dollar performance over time - a valid fear taking into consideration the seems-to-never-end QE - Hedge the USD, not the US!

The Japanese Yen is Undoubtedly the Ultimate SHORT

The real crisis brewing - and the one that no one seems to notice - is in Japan. The land of the rising sun is a ticking time bomb, and when it finally blows up, it will make all the talk of eurozone disintegration seem petty by comparison.

Japan is the most heavily indebted nation in the world with government debts of more than 220% of GDP and a gaping budget deficit of nearly 10% of GDP.

To put that in perspective, Greece, Spain and Italy - the European countries most viewed as being at risk of default - have debts equivalent to 160%, 68% and 120% of their respective GDPs. The United States recently tripped over the 100% mark, but for all of the (completely justified) fretting about out-of-control debt in America, Japan's debts are more than twice as big.

Japan spent a good part of 2012 in recession.

Japan has racked up the biggest debts in modern history trying to stimulate a dead economy, yet it still has been in and out of recession for the better part of the past two decades. It's hard to see that extra few trillions yen making much of a difference at this point. Haven't we been there already?...

I know, I know. Japan is different. This time is different.... isn't it?

Some say that unlike America and Europe, most of its debts are held by its own population, so there is little risk of international bond vigilantes punishing the country the same way they've punished Europe's problem children. Plus, the Japanese culture is known to be conservative, and people there save a high percentage of their income...

If your money manager or financial adviser has told you this, pick up the phone right now and fire him.
I say this in complete seriousness. Anyone who says something that phenomenally stupid should not be allowed to manage money professionally. Yet there appear to be plenty of them out there, because the Japanese yen has been pushed sharply higher in recent years by investors who are delusional enough to consider the country a safe haven.

Think I'm being too harsh?

Let's look at some very simple demographic math. Those high savings rates we all heard so much about last decade were a product of Japan's high-income earners in their 50s and 60s socking away money for a retirement they knew was quickly approaching.

Well, it came. Japan is the oldest country in the world with the highest percentage of its population beyond retirement age (roughly a quarter). And as Japan's Post-WWII generation drops out of the work force, they are starting to dip into those savings they spent the past three decades accumulating. Japan's savings rate is now just 2% and falling - a far cry from the 44% savings rate it recorded in 1990. If it has not dipped into negative territory already, rest assured that it will soon.

The legions of Mrs. Watanabes that Japan has depended on to buy its government debt are no longer saving and investing. They are living off of their past savings and, given how low interest rates are, probably will be selling a good chunk of those bonds in the years ahead.

What then? What do you expect will happen to Japanese government yields when the Japanese have to turn to the international bond markets for the first time?

They could turn to the Bank of Japan, of course. And in fact, that is exactly what Shinzo Abe is advocating. Abe has called for "unlimited" bond buying, and not just in the secondary markets. He wants the bank to lend money to the government directly.

We have the pieces in place for a hyperinflationary meltdown. This might sound impossible given that Japan has had on-again/off-again deflation for the past two decades, but it is hard to see any other outcome. As Japan's borrowing costs inevitably rise, it will have to fund more and more of its budget via the central bank.

And from that point, the path to hyperinflation becomes a slippery slope.
Investors eventually will lose their faith in the Japanese yen, as we see these days. And when they do, the value of the yen will plummet and the prices that Japan pays for imported products and materials will soar … and that will necessitate more money printing.

In Endgame, John Mauldin called Japan a "bug in search of a windshield", and it's an apt metaphor. It's just a question of when it will splat and what the particular windshield will be.

Right now, the Japanese equities markets are rising parallel to the JPY declining. I don't believe that this can move on for too long. Looking at the Japanese economy, one can't justify the sharp move up of stocks. Based on fundamentals, it's not sustainable.

For now, it's a waiting game. I see it creating an incredible short opportunity in Japanese assets. If you missed the opportunity in 2008 to short subprime lenders and banks, fear not. You'll almost certainly be able to make a bundle shorting the yen, Japanese bonds and Japanese stocks.

In the meantime, keep an eye on Japanese interest rates. When you see them starting to rise, you might want to start setting yourself up for the short opportunity of a lifetime.
It is a little shocking to me that the JPY spent so much time sub-100. We just started a correction. If you ask me, the JPY should trades above 200. I'm not saying it will go there, but I'm saying it should be there.

Conclusion

We all know that, "The market can stay irrational a lot longer than you can stay solvent." Nevertheless, investors and market speculators should analyse promises, observe QE purchases as a percentage of gross domestic product or outstanding debt, and sell the most serial offender or obsessive compulsive printer.

The yen, as described above, is clearly the first choice, with the pound a close second based on incoming Bank of England Governor Mark Carney's inaugural addresses. Amongst the main developed economies, the Euro is probably holding up the rear, simply because of the ECB not participating in the mega printing money game. Unlike his American, British and Japanese colleagues, the European central bank president Mario Draghi may promise to do everything within his power to save the euro but so far that hasn't meant printing many of them.

Picking winners and/or losers based upon the increasing size of a central bank's balance sheet may prove itself over the short-medium run. Nonetheless, an investor should understand that all of these QE bullets and very loose monetary policies may produce an impression of real growth but they will surely produce more inflation over the long run.

Source: The Currency War: Position Yourself Correctly In The Battleground

Additional disclosure: I'm currently LONG EUR, TRY, INR, BRL and USD through specific bonds and equities, not thorugh currencies or ETFs.Despite being a long-term SHORT JPY I'm currently sitting on the sidelines, looking to enter into a new SHORT JPY position soon.