First Shots Are Fired in Global 'Currency War'

Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace. (Read More: Japan PM Says BOJ Must Set 2% Medium-Term Inflation Goal)

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

While respective countries would have their own versions, the moves would follow three years of aggressive bond buying from the Federal Reserve as part of its $3 trillion quantitative easing program.

Though critics worry about the long-term consequences, the three rounds of QE have managed to keep the U.S. economy afloat and have boosted risk assets such as stocks and commodities.

"Ever since the Fed launched QE2 in August 2010, we have been in the currency-war regime," said Alessio de Longis, portfolio manager of the Oppenheimer Currency Opportunities Fund. "It will continue to be this."

In a late-2012 announcement, outgoing Bank of Japan leader Masaaki Shirakawa indicated an aggressive easing program that would total 50 trillion yen over the next year or so.

The move is part of Abe's plan to get the country out of its two-decade deflationary spiral, but has generated mixed reaction.

Dollar, Euro and Iranian Rial
Atta Kenare | AFP | Getty Images
Dollar, Euro and Iranian Rial

"The economic policies of the new administration are set to be centered on loose monetary policy and fiscal pump-priming," Citigroup analysts said in a research note. "However, experience suggests this is unlikely to lead to a sustained revival of the Japanese economy."

Still, a declining yen would help Japanese exports and put upward pressure on other currencies, something unlikely to be tolerated by its competitors.

The massive Fed balance sheet expansion has resulted in the U.S. dollar declining about 11 percent against a basket of world currencies since QE began in 2009. In the meantime, stock prices have doubled since their March 2009 lows and the Morgan Stanley Commodity Related Index has gained about 80 percent.

With the U.S. as its guide, competitive devaluation is expected to accelerate.

Strategas investment strategist Jason Trennert included the "race to the bottom" as one of his five principle investment themes of the year.

"Recent actions on the part of the Fed, the ECB, the Bank of Japan, the Swiss National Bank, and the Bank of England all suggest that financial repression (or the perpetuation of negative real rates on sovereign debt) is likely to be the most enduring investment theme for the foreseeable future," Trennert said.

In 2012, global central banks cut interest rates some 75 times in an effort to create conditions that would spur growth.

Economists, though, expect growth to meander around 3 percent globally this year, a level generally considered to reflect little actual growth at all. (Read More: US Economy to Grow 2.5% This Year: Fed's Evans)

The hope, though, for those engaged in currency devaluation is that it cheapens the price of their goods globally and thus increases exports and creates positive inflation.

But the initial stages of inflation are usually bad for stocks and send investors to commodities and fixed income indexed for inflation, such as Treasury Inflation Protected Securities.

"So what could cause a market correction over the first half of 2013?" Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, said in an analysis. "In our view it will either be 1) a rapid rise in interest rates and a re-run of the 1994 story; or 2) the economy fails to respond to the liquidity, forcing nations to devalue their currencies in an attempt to stimulate growth."

The Standard & Poor's 500 slipped about 4 percent in 1994, losing ground through year as the Fed tightened policy to control the recovery. Of course, a major bull run began the following year, with the index soaring 32 percent in 1995.

Though the release of the most recent Fed minutes scared some investors into thinking the Fed might normalize rates sooner than expected, those fears since have been largely dismissed.

Other central banks around the world are likely to take note. (Read More: Has Draghi Won the Battle With Financial Markets?)

"It is clear that many nations want/need a weaker currency – should China also feel the need for a weaker (currency)...then the risks of a risk-negative (currency) war would start to grow," Hartnett said. "Gold would rally sharply, but note a rise in gold prices and a fall in bond prices precipitated the 1987 crash."

He advised clients to keep a close watch on the Chinese yuan and the broader Asian dollar index.

Oppeheimer's de Longis adds the Colombian peso to that list as well as the New Zealand and Australian dollars, with others in South America and Europe possibly joining as well.

He fears that while the short-term effects could be positive for those countries involved as well as the risk assets associated with such moves, the long-term consequences could be onerous.

"These policies are creating the preconditions for central banks around the world in, say, five to 10 years from now to ask, 'How do we shrink these balance sheets in an organized and gradual manner?'" de Longis said. "History tells us that these large experiments, especially on a global scale, don't end up being unwound in an orderly manner."

—By CNBC's Jeff Cox