Shanghai Meet: Great Expectations

Backroom currency deals in Shanghai? More going on than meets the eye? Probably a golden opportunity here for investors.

Economic Times reports that the US dollar has just been knocked down and forced to serve the interests of the world against the will of the  American people. The dollar has been Shanghaied! Based on the best information we've been able to obtain, it looks like the dollar has just been Shanghaied by the G-20 (the unelected, unaccountable group of 20 nations that collectively control the world monetary system). This could be the most important financial development of 2016, with enormous implications for your portfolio. This new effort to knock out the dollar was contrived at a secret meeting in Shanghai on February 26. 

The list of names reads like a rogues' gallery of central planners and currency manipulators. Janet Yellen from Fed, Christine Lagarde from IMF, Mario Draghi from ECB and US Secretary of Treasury Jack Lew were there, along with their central bank and finance ministers from Japan, China and BRICS. The main meeting of G-20 finance ministers and central bank governors was no secret. A side meeting of a core group comprising the US, Europe, Japan, China and the IMF was a secret. This group calls the shots. The US, Europe, Japan and China together represent over 70% of global GDP. The IMF acts as a facilitator for these secret meetings, and an "enforcer" for agreements reached behind the closed doors. The outcome of this secret side meeting was the biggest dollar take-down operation since the Plaza Accord of 1985. 

The Plaza Accord was orchestrated by James Baker, who was Ronald Reagan's secretary of Treasury at the time. The dollar increased almost 50% between 1980 and 1985, and reached an all-time high that year. The strong dollar was hurting US exports and jobs. The Plaza Accord was a coordinated effort by the US, France, West Germany, Japan and the UK to weaken the dollar. The dollar fell 30% over the next three years. The US economy got a second wind, and the Reagan-Bush expansion continued. Now the dollar is at a 10-year high on major indexes. It's time to trash the dollar again. But the US does not have the same skillful leadership we had in James Baker. This time, the big winner won't be the US; it will be China. The losers will be the same — Japan and Europe. Understanding these backroom machinations requires some analysis. 

Currency manipulations are negative sum games. One country can get a small temporary boost from devaluation, but trading partners are worse off, and the world is worse off. Ultimately, even the country that devalued first is worse off after others retaliate. A new theory of currency manipulation was created by Ben Bernanke which says that if every country eases at the same time, everyone gets the benefit of easing, but exchange rates don't change because of coordinated timing. Bernanke called this "enrich thy neighbour," in contrast to "beggar thy neighbour" name given to currency wars in the 1930s. Cooperation and coordination among central banks can be carried several steps further. Several countries can ease or tighten at the same time to give one country some relative benefit by design. Central banks can give targeted relief to one country if they all cooperate in a secret plan. Central bank policy changes work through expectations as much as action. In traditional policy, a central bank eases by cutting rates or tightens by raising rates. But it can also ease by raising expectations about a rate increase and then doing nothing. If markets price in a rate increase and the central bank does nothing, markets can rally on the news. This is like an invisible rate cut, based on changed expectations. Having multiple central banks manipulate expectations and coordinate policy behind the scenes is complex. These efforts are doomed to fail because of unintended consequences and exogenous shocks. But that won't stop the big brains from trying. 

This brings us to China's shock devaluation of the yuan last August. Because China had not managed expectations, this shock destabilised the global financial system. The IMF and Fed were quite upset that China was not playing by the rules of the game. China did not care about the rules, because their economy was sinking under bad debts and capital outflow. With this and the yuan shock, the global financial powers descended on Shanghai in Feb. The G-20 central bankers and finance ministers agreed that China needed help. It's the world's second-largest economy and it was falling. There was danger it could take the world down with it. Further yuan devaluation was not possible (in short run) because it was destabilising to markets. The solution is to weaken yuan on a relative basis by strengthening the currencies of China's trading partners, Japan and Europe. If the yen and euro get stronger, that's the same as making the yuan weaker, but without the shock of Chinese devaluation. Since this secret deal was worked out on February 26, the first chance the central bankers had to put their plan into action was mid-March. 

The ECB met on March 10. The Bank of Japan met on March 15. The Fed met on March 16. All three would be able to implement the secret plan in just five business days. It was "game on" for the biggest currency manipulation since 1985. Yet how could Japan and Europe tighten without explicitly raising rates? They did it by raising expectations. Markets thought Draghi's ECB "bazooka" would be long lasting. Markets expected Kuroda of the Bank of Japan to do more aggressive QE. In fact, Draghi did the minimum necessary, and then said he was done doing more. Kuroda did nothing. Both decisions acted like tightening relative to expectations. The euro and yen went up against the dollar. Comparatively, the yuan went down with no devaluation by China. This was the new Shanghai Accord in action. 


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