Morgan Stanley: There's No Currency War Yet, But Here's What Could Trigger One

Despite all the rhetoric, Morgan Stanley still doesn’t think there’s actually a “currency war” just yet.

What would such a war actually look like?

However, one crucial ingredient that would suggest we are in a currency war still seems to be missing – retaliation. Rather, these currency movements and the understandable policy response are symptomatic of a two-track global economy where low-growth and über-easy monetary conditions in DM has led to capital flows seeking to benefit from the robust domestic demand-led recovery in EM, which in turn has helped EM risky assets to outperform (see Exhibit 1). EM policymakers have, as a group, deployed similar tools this year when faced with similar issues in a synchronised but not necessarily retaliatory fashion.

We think they might be a tad sanguine here. China’s sharp response to currency pressure — and the ensuing weakening of the yuan — smells a little bit of retaliation.

But anyway, here’s what Morgan Stanley sees as a possible trigger:

Possible triggers: G10 growth shock, EM growth shock, large QE in the G4: Possible triggers could come from growth or policy shocks from the G10 or from the EM world. Growth shocks to the G10, most importantly to the US economy, could result in dollar weakness that could exacerbate the two-track nature of the global recovery. Alternatively, a shock that resulted in weaker EM growth might lead to a protectionist reaction from domestic policymakers. Another source of tension would be divergence and conflict within the EM world itself, with slowing economies trying to depreciate their currency values but faster paced economies unwilling to sacrifice exports and growth in order to pull them along.

But even less extreme scenarios may lead to a ramping up of ‘beggar-thy-neighbour’ policies. Another round of QE from the Fed is already in the price and in our forecasts and in USD weakness (see Emma Lawson’s “G10: Passing the Buck”, FX Pulse, September 30, 2010). However, since the program is likely to start as a small and open-ended one (WSJ/Hilsenrath), the currency move has so far been orderly. The risk of a ‘currency war’ would arise if the Fed were to deliver a much larger-than-expected program, which could push the dollar lower in an abrupt fashion. With Fed communications becoming less divergent and more blunt over the last few days, the diminished probability of a miscommunication may reduce that risk.

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