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Market Commentary
FX Alert – QE2 as USD end-game
Steven Englander
+1 212 723 3211steven.englander@citi.com
Recent extremely weak economic data have increased the odds of asecond round of QE.
With Treasury yields and MBS spreads already low, a second round ofQE could be more aggressive and less orthodox than the first.
Further expansion of the Fed’s balance sheet and more direct efforts atreflating the US economy will likely put downward pressure on the USD.
A second round of QE will likely put sharp downward pressure on the USD, to some degree versus the euroand other G10 currencies, with potential for a broader USD sell-off. Foreign investors are likely to view therenewed direct intervention as indicating that the Fed’s balance sheet expansion and implicit monetization offiscal expenditures are first line approaches to dealing with disappointing recovery prospects, rather than theexceptional measures they were meant to be initially. This could have severe implications for foreignperceptions of the quality of the US assets that they are accumulating in private and official portfolios, andmay lead them to draw the conclusion that USD weakness is less a by-product than a desired outcome ofthese measures.It is hard to argue that the EUR and JPY do not share some of the same weaknesses. However, the eurozone is essentially self-financing, with private savings offsetting almost all public deficits, and fiscal deficitsremaining considerable smaller than in the US. Moreover, the euro zone’s fiscal austerity provides acredible, if painful, signal of an underlying desire to reduce fiscal imbalances that so far is lacking in the US.Even if the ECB maintains its ‘pragmatism’ on the collateral front, the reluctance to buy significant quantitiesof government debt signals a desire to return to orthodoxy.From a currency perspective the euro zone combination of external balance, fiscal austerity, ECBpragmatism and reluctant sovereign buying is likely to be more attractive than the US mix of QE2, limiteddeficit reduction and the need to finance a growing external imbalance while offering increasingly low rates.Buying a little government debt while austerity is put in place is ultimately more credible than buying a lotwhen austerity is not put in place.We are more sympathetic to the view that the USD/JPY is close to its trough. The stronger yen isincreasingly negative for growth and wealth (through the reaction of equity markets to yen strength).Japanese real interest rates are much higher than elsewhere in G3 because of deflation. This is not really acurrency plus because it is impossible for investors to arb the Japanese and USD CPI against nominalinterest rate differentials. It creates a headwind to growth that becomes more severe as deflation intensifiesand the yen appreciates.To be sure the major euro risk remains that the austerity and slowing global growth will slow euro zonegrowth to such a degree that a sovereign default occurs and has severe knock-on effects on other fiscallyweak countries. That clearly remains the major euro zone risk. However, investors have tolerated prior ECBintervention well, and the ECB’s reluctant intervention to avoid the worst in sovereign debt markets has beeneuro positive.
Concern that monetary policy is ineffective
Recent downward surprises in housing and investment data suggest a deepening risk that the US is enteringinto a significant slump. Given the run of very weak data investors are now focused on the policy response,with comments by Fed and international officials at Jackson Hole the ‘payrolls’ event of this week. Centralbankers are loath to admit that they may be pushing on a string, although the combination of balance sheetconstraints at commercial banks, idle balances throughout the financial system and low loan demand byborrowers make this a possibility. Moreover unlike the first run at QE, neither the level of rates nor spreadspoint to an obvious problem that a new round of QE can solve (unless they decide to buy Greek and Irishdebt). Our US Economists have stressed that “… monetary policy will need to err on the side of ease…. The[Fed] reinvestment plan likely will be enhanced by more active balance sheet expansion or perhaps newefforts to unblock credit.”Consider the options raised by Alan Blinder in today’s WSJ (he characterises the Fed policy hand as weak):1) Treasury and MBS spreads are already low, so the mileage out of further Fed buying may be limitedunless they go much deeper into private sector assets; 2) Committing to an even longer period of low rates
CitiFX
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& LM Strategy
August 26, 2010
CitiFX
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& LM Strategy
August 26, 2010
Market Commentary
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(as also suggested by our FI Strategy team), but subject to the risk that the commitment language is notsufficiently effective; 3) Paying negative rates on reserves as a way of getting idle balances into the loanmarket; 4) Getting bank examiners to ease up on healthy banks willing to make loans. Our US economistshave argue similarly that financial conditions remain tight and targeted policies may be needed to ease creditconditions in segments that have not benefited so far.To be sure there is a second view that argues that the liquidity injections are doing no good and willultimately do harm. For example, the University of Chicago’s Raghuram Rajan argues that the current levelof low rates are a subsidy to borrowers and risk takers, and like all subsidies will induce excess consumptionof the subsidized item, in this case risky investments. (This week’s WSJ article on Fed dissension impliesthat he may have some sympathy among regional Fed Presidents and even some Governors.) Over thelonger term the low rates will add to moral hazard by conditioning risk takers to expect bailouts.Despite the sympathy of some FOMC members, it is hard to see how far these arguments will influencepolicy, unless accompanied by a positive argument for an alternative set of policies to reduce unemploymentand excess capacity. (Cutting real wages is hardly a policy runner given that there is no evidence that theyare too high. If anything higher wages would make servicing mortgage debt easier rather than harder).
Debt still out of line with ability to service it
There does seem to be a consensus is that a broad gap remains between how debt is priced on the books ofborrowers and lenders and the ability of the associated assets to service that debt. The fundamental policyquestion becomes how to get this relative price between debt and the ability of assets to service it back inline. The first approach was to hope that fiscal and monetary stimulus would buy time for asset prices tostabilize and the debt servicing capability to rise (and that approach pretty much worked during the S&Lcrisis of the late 80s and early 90s, although policy was then more focussed on finding market clearingprices.). Until recently that muddle-through approach seemed to be working but the weak economic data ofthe last two months and especially the last couple of weeks have put that in question. Recent inflation andgrowth numbers, if anything, suggest that the gap between debt servicing capability and asset prices may berising rather than narrowing.
How will the USD respond?
Given the risk of falling into a double dip, a wide variety of unconventional responses are likely to bediscussed. The frustration with the potential long-term debt servicing costs of pure fiscal stimulus and theconcern that monetary policy on its own is pushing on a string may lead to discreet discussions of large andmore directly monetized fiscal policy. The advantage of the joint approach is that it works directly onaggregate demand (and thus is not pushing on the proverbial string) and does not carry the long-term debtservicing consequences of borrowing from the private sector (the Fed is printing money). The fiscal thrust
Figure 1. Treasuries bought in bulk by foreigners Figure 2. Inflation and low rates in post-WW2 US
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U S D b n
0123456789101940-011942-011944-011946-011948-01
p e r c e n t
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I n d e x
10 yr treasury yield (left)30 yr treasury yield (left)CPI (1945=100)
Source: US Treasury, Citi, as of 26 August 10 Source:: Ecowin, Citi, as of 26 August 10
CitiFX
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& LM Strategy
August 26, 2010
Market Commentary
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could be embedded through the tax system or direct government spending.That the monetized fiscal policy will likely increase inflation expectations and lead to selling of the USD byforeigners is either an advantage or disadvantage depending on your perspective. If stronger activity and ahigher price level means that the private (and increasingly public) debt incurred over the last ten years couldbe serviced, albeit with creditors taking an inflation-induced haircut, the imbalance between asset prices anddebt servicing capability could be unwound.For those who think that the post-war period was the heyday of successful macroeconomic policymaking,consider that the price level went up by 35% between the end of WW2 and mid-1948, while 10yr and 30-yrTreasuries yielded about 2.0% (Figure 2). It is hard to argue that inflation has not reduced the real debtburden in the past, and that risk will continue to weigh on the USD. If anything, the floating USD as opposedto the fixed Bretton Woods USD of the late 1940s would aid in adjustment.
The combination of the Fed anchoring rates at the short end and supporting fiscal policy through balancesheet expansion would certainly make it clear to foreign investors that the USD assets they are buying(particularly the Treasuries) carry a degree of long-term risk. It would also signal that the US was willing toinflate itself out of its debt problemsThe long-term disadvantage is that monetary policy credibility would be lost for a long time, if not forever.Borrowing costs would be higher at full employment and policy would be viewed as having exercised ahyper-Greenspan put. The cost of lost long-term credibility is a real cost, even if somewhat difficult tomeasure, but there is also a real gain from closing an output gap that is estimated to be in the 6-7% of GDPrange.
QE more effective than USD intervention
Renewed significant balance sheet expansion, particularly if viewed as implicitly monetizing government debtis probably more effective than conventional intervention at weakening the USD. It is not straightforward tointervene against (Asian) currencies that do not trade freely in capital markets. In fact it is close toimpossible, so standard steriliized intervention is not feasible.Balance sheet expansion and QE are unsterilized injections into the financial sector and economy. Unlike hitand run intervention, the impact is long-lasting and sends a clear message to foreign investors that the USauthorities are willing to alter the supply-demand balance for US assets. It does not directly prevent thebuilding up of USD reserves, but it alters the incentives for such accumulation when the risk is high that thevalue of the accumulated reserves will drop. If US policy markers really think that the level of the USD is animpediment to recovery, this is the ultimate credible signal that the US authorities are determined to force anadjustment.One implication is that the currencies that might appreciate the most are those of reserve managers (andespecially those with rapidly accumulating reserves) because they stand to lose directly from a largeincrease of global US assets and they have the most concentrated holdings. Recall that 60-65% of globalreserves are still in USD. Private sector investors very likely are more diversified in their holdings.
Unorthodox policies to weigh on the USD
And what if US policymakers hold off on QE? Our US Economists see them as highly responsive, but notfully convinced yet. In the near term, policy reticence is probably a USD plus, even if the mechanism isthrough acute disappointment in US and global asset markets. However, as long as the growth that emergesin the rest of the world is steady, even if at a lower pace than desired, the USD would likely come underpressure, albeit more gradually.It is difficult to gauge the set of policies that US policymakers will pursue to reduce the risk that the USslumps into a significant slowdown. In the current environment of extremely disappointing growth andapparent lack of response to traditional monetary stimulus, policies that are less than orthodox are likely tobe considered seriously. Most of these unorthodox polices are likely to weigh on the USD.
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