Is a Currency War Even Possible in 2020?

The pandemic continues to rattle the global financial markets, but despite that, markets had been increasingly optimistic over the past few weeks. Stocks markets had recovered and risk currencies rallied as dollar funding pressures had eased and the number of infections reached a plateau. However, despite the short-term positive mood, several risks lie ahead, with one of them being a currency war.

A flaw in the financial system?

One of the things forex traders need to be fully aware of is that in a global fiat monetary system currencies are valued against each other. This means when one currency goes up other/others go down and vice versa. Since COVID-19 had forced a lockdown in many areas around the world, economic activity had weakened to levels not seen since the end of WWII. This creates a huge problem for countries that already have large debt-to-GDP ratios.

They have to finance their outstanding debt in a period when incomes are dropping, while at the same time, they need to borrow more to counteract the negative consequences of the economic downturn that had already begun. This will lead to all central banks reducing interest rates and printing money.

This happens because they not only need to provide enough liquidity to interest rates spike higher but at the same time stimulate inflation and currency debasement. The main goal is to create a big inflationary pressure that should compensate for the deflationary effect of the economic contraction.

When could we have a currency war?

What many forex traders don’t factor in is that the pandemic had contributed to an acceleration of a deglobalization process. Coordination and compromise made the financial system work for the past decades and now we see protectionism and nationalism emerging once again. Personal interest is all that matters and countries will put themselves first when things start to work badly.

Right now, a currency war is not very likely, given that despite political hustles mainly between the United States and China, central banks had acted as they should provide the liquidity needed to cover the funding gap. As long as that will continue, we expect the US dollar to remain elevated against its peers, as other central banks will print more and devalue their currencies. However, at some point in time, the dollar will need to go down as well, since we have more than $20 trillion of dollar-denominated debt outside the United States.

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