The economy is a strange beast. Although it has proven to be an effective tool for domestic and global trade, it is far from being perfect, and new fundamental issues pop up from time to time.
But one thing is certain – in the way financial markets work, currencies are the center of attention in every economy. Central bankers can use their currency to boost their economy and vice versa, which has happened in most economies since the 2008 financial crisis.
Japan, for example, was a perfect case for a country that tried to weaken its currency to increase its growth. In a way, for many years, it was the only tool for the Japanese central bank to improve the country’s GDP and survive in a difficult economic situation.
But lately, inflation has become the biggest concern for policymakers and the global economy. Consequently, with rising global interest rates, we are entering a new era of a reverse currency war where countries aim to strengthen their currency versus other currencies to control high inflation rates.
The new market rules will have a significant impact on the forex market as well as any other financial market. Therefore, as a trader, you must be aware of the reverse currency war phenomenon and how to approach it.
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What is a Reverse Currency War and What Does It Mean?
In simple terms, a reverse currency war is a deliberate act by central banks and governments to strengthen their currency.
It is the opposite of a currency war wherein countries try to weaken their currency to boost the local economy by increasing income from exports – a weak currency means a more considerable income for exporters. Either way, countries, especially trading partners, get involved in currency wars to gain an unfair advantage in international trade.
It is not a conventional war with weapons; however, it has a massive impact on global trade and may cause serious conflicts between countries.
So, why is it happening now? Why do countries worldwide want to appreciate the value of their currency? In a word, inflation!!!
Think about it, if a country can fight inflation by raising interest rates and strengthening its currency, then most countries will aim for this solution. A strong currency means that imported products are cheaper, and thus, the core inflation rate can be significantly reduced.
On the other hand, the downside is that a strong currency means exporters receive a smaller amount for their exports, which could result in slowing economic growth. Further, many countries are concerned about a debt crisis that may occur due to rate hikes.
This is the case, for example, in the European Union, where the ECB must find the perfect balance – that is to follow the Fed’s rate hikes so the interest rate differential will not get wide and at the same time, not raise rates too much so the EU debt crisis will remain in control.
So, central banks – choose your poison, high inflation rate or slowing economic growth. That’s the situation central banks worldwide currently face due to the stagflation phenomenon that occurs in most economies. They have to raise interest rates to prevent high inflation while at the same time, they must ensure their currency is not depreciating rapidly.
How to Trade in the New Era of Reverse Currency War?
Over the last few months, the foreign exchange market has become a hot topic with high volatility and sharp price movements. The big question for the average trader is what to do, meaning how to analyze the markets in the new circumstances? Using the Wyckoff theory, which claims that a single entity allegedly controls markets, you can use the reverse currency war phenomenon to indicate what central banks aim for.
For example, the US dollar has risen significantly against major global currencies, including the Euro. For the first time in over two decades, the USD is nearly equal in value to the Euro. Obviously, this trend is likely to continue in the next year.
Taking the above into account, here are some things you need to keep in mind as a forex trader:
Carry Trade – Follow Interest Rates Announcements
The first thing you need to do is be aware of interest rate differentials and the expectations of rate hikes by central banks. Usually, carry trades are the main driver of why a particular currency strengthens versus the other.
If you are not familiar with the term, a carry trade is a popular trading strategy that involves buying a currency with a high-interest rate and selling another with a low-interest rate. By doing so, investors can exploit the interest rate differentials and receive an annual return.
Given the fact that interest rates are expected to rise in most countries, every trader must follow the interest rate of each country and more importantly, the rate hike expectations for the upcoming year. One tool to follow the rate hike expectations in the US is FedWatchTool which shows the target rate probabilities of the Federal Reserve’s next meeting.
Find Currency Pairs with Wide Interest Rate Differential
Even though most countries compete to appreciate their currency value, some countries are still behind in the process. For example, the Bank of Japan (BOJ) has kept interest rates at low levels over the last year despite the inflationary pressure. Expectedly, the widening interest rate differential caused the USD to strengthen by more than 18% versus the Japanese Yen (Since the beginning of the year, the Dollar-Yen exchange rate rose from 115 to 136).
Consequently, traders must find these opportunities and take long-term positions by holding the high-yielding currency and selling the low-yielding currency. It is also advisable to look for stable emerging and developing economies with a wide interest rate differential compared to other major rich countries.
Wait for the Next Cycle
So far, the Federal Reserve was the first bank to aggressively increase interest rates. Unsurprisingly, the dollar index (DXY) rose by nearly 12% from the start of the year versus all major currencies. The US dollar has a unique role in the international currency system as it serves as a global reserve currency. As the US dollar appreciates, the inflationary pressure increases worldwide.
Looking ahead, it is very likely to see the US dollar keep its positive momentum by the end of the year and even beyond that (some believe that the DXY may rise to 120 and higher). However, central banks of developed countries can not allow a wide interest rate differential versus the greenback for a long period of time. This may result in a new cycle where major currencies will appreciate versus the US dollar to tighten global inflation and to avoid a situation in which leading European countries are entering a debt crisis.
“With high global inflation likely to persist for some time, the prospect of reverse currency wars is looming larger. Instead of a race to the bottom in the foreign-exchange market, we may see a scramble to the top – and poorer countries are likely to suffer the most.“Jeffrey Frankel
The Bottom Line
In summary, the raging inflation rates across the globe have changed the dynamics of the forex currency market and the world economy in general. So far, we can see the confusion of central banks and international economists worldwide to find the perfect balance to strengthen their currencies and fight inflation while at the same time achieve exchange rate stability.
Further, the concerns of stagflation amid a slowdown in growth and rising prices have prompted analysts to predict a new era of reverse currency wars. Indeed, this seems to be the policy applied by most central banks worldwide and many trading partners are deliberately trying to strengthen their currency to control high inflation rates.
For traders and investors, it is crucial to understand the shift in markets from the previous currency war condition over the past decade in which central banks tried to weaken their currency. Now, central banks will use all the tools they have to appreciate the value of their local currency to bring down inflation rates.
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