“What Mario did [March 10^th QE announcement] was to engineer a credit easing without a currency devaluation. And my suspicion is that this was all part of a gentlemen’s agreement back at the G20 meeting.

Here was what I think happened in Shanghai. The Bank of Japan and European Central Bank proclaimed that they were both going to ease aggressively in March. The Peoples Bank of China then said, well if you drive the EUR to parity and JPY to 130 with deeper negative rates, we will break the $US peg. And that’s when everyone said, ooohhh not so fast.

It was surely well understood by all participants that the August and January Chinese yuan moves had destroyed all the hard reflationary work the ECB and BoJ had done since Q4 2014. And a full break in the yuan peg would bring a further nasty and unwieldy tightening in global financial conditions (i.e. our 1998 argument). No one wanted that!

Also, it was no doubt widely understood by all those involved that the Chinese (with the peg in place) could not take a significant strengthening in the $US given their domestic debt and growth situation.

So the players in this very complex currency war game all sat down and came up with a simple agreement. The ECB and BoJ would focus purely on the domestic credit-easing channel. They would not use these highly powerful negative rates (and forward guidance) to lower risk-free real rates, and in turn weaken their currencies.

Further, the Fed likely gave assurances that it would not rates, and in turn weaken their currencies, or remove accommodation too quickly via rate rises. That would also keep the US dollar in check and give the Chinese time to use fiscal policy and structural reforms to manage the unwind of their debt bubble.

All that said, I can imagine the Fed is thinking long and hard about ways to focus less on rate rises and more on a domestic credit tightening if conditions warrant further accommodation removal. The exchange-rate externalities which arise from using rates may simply be too problematic given the delicate bilateral “détente” structure between the PBOC and the US’s Financial Oversight Management Committee. That is certainly some food for further thought.”

Source: analyst David Zervos in his client letter quoted here