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Nomura QE&USD Int'l Lessons (Part II) 2010-09-22

Nomura QE&USD Int'l Lessons (Part II) 2010-09-22

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Nomura Securities International, Inc.
See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures
FX Insights
FX Research and Strategy
 
QE and the Dollar: International Lessons (Part II)
The experience from QE- 
1 showed a clear USD weakening impact from the Fed’sasset purchases. But the international experience is more mixed. The UK’s QE 
policy in 2009 did provide a weakening impulse on the GBP, but the Japanese QE experiment, starting in 2001, did not. Whether QE will trigger FX depreciation is likely to depend on the impact QE has on inflation expectations and implied real 
rates. Importantly, the Fed’s ability to move these parameters
depends on the starting point for expectations. From current levels, Fed asset purchases are likely to be less potent than was the case at the outset of QE-1.
Two weeks ago, we analyzed the impact that quantitative easing by the Fed fromDecember 2008 to March 2010 had on the US dollar (see
,10 September 2010). Here, we look at the internationalexperience with quantitative easing, using the lessons from QE in the UK (2009)and in Japan (2001-2006).
The UK QE Experience (2009
): Our analysis shows that QE had a significantimpact on UK nominal yields and on sterling. The cumulative decline in the trade-weighted GBP around the six key announcements pertaining to Bank of England(BoE) asset purchases (QE) amounted to 4.0%, broadly consistent with recentanalysis by the BoE. The finding should be viewed in the context of a graduallyrecovering GBP (from a very weak level) during the period of QE as a whole. Interms of the transmission mechanism, it appears that the QE managed to depressreal yields, while breakeven inflation was not much impacted by the BoE
‟s
assetpurchases. Specifically, around the key announcements, nominal yields dropped acumulative 80bp, of which roughly 50bp was accounted for by declining real yields(while only 30bp was due to lower inflation expectations). For further detail, seeAppendix I.
Japan’s experience (2001
-2006):
Our analysis shows that Japanese QE had verylimited measurable impact on Japanese yields and the yen. There is a longliterature on this, and in general our results are consistent with the consensus inmore academic analysis of the impact of Japanese QE. We analyzed 16announcements relevant to Bank of Japan QE policy, and found that the QEannouncement never triggered a decline in 10Y JGB yields of more than 3bp overa 2-day window. Moreover, the cumulative impact was for JGB yields to increasemarginally. Due to the lack of an inflation linked market in Japan before 2004, it ishard to decompose yield moves into inflation expectations and real rateexpectations. But consistent with the notion that neither inflation nor real rates
Figure 1. Cumulative FX performance around QE announcements
 
Note: Initial announcements for JPY, GBP, and USD occurred on 3/19/01, 2/11/09 and 11/25/08,respectively. For event-specifics, please see relevant appendices. Source: Nomura.
 
-7-6-5-4-3-2-101230 1 2 3 4 5 6 7 8 9 10 11 12%
months following initial announcement
JPY (from 3/19/01)GBP (from 2/11/09)USD (from 11/25/08)
 
22 September 2010
 
Contributing Research Analysts 
Jens Nordvig
Anish Abuwala
+1 212 667 9934anish.abuwala@nomura.com
 
 
Nomura| FX Insights September 22, 20102
moved noticeably in response to QE announcements, we find that the yen wasvery unresponsive to the QE policy, with median and cumulative moves ofessentially zero, despite the fact that part of this balance sheet expansioncoincided with a period of FX intervention (the heavy bulk of which occurred fromJan 2003-Mar 2004). For further detail see Appendix II.
The US experience (Nov 2008
 –
Mar 2010
): Our analysis of Fed quantitativeeasing episode showed a notable impact on the dollar, even when controlling forthe effect of improved risk sentiment and improving USD money market conditions.We find that the USD index declined 8.2% around key announcements pertainingto QE, driven mainly by significant declines in real yields, with additionalcontribution from rising inflation expectations. Meanwhile, we find that theimmediate impact from improved money market conditions and better risksentiment was small in the short intervals around QE announcements. For furtherdetail, see Appendix III.
When does QE lead to FX depreciation?
In theory, QE should impact the spot exchange rate to the extent that it can alterinflation expectations and real interest rate expectations. Specifically, we wouldexpect currency weakness to the degree that QE pushes inflation expectationshigher and/or QE manages to reduce real rate expectations. The reasoning is 1)that higher inflation will necessitate a weaker nominal exchange rate at a given(equilibrium) real exchange rate, and 2) that lower real rates will allow for a weakerspot exchange rate currently in order for interest rate parity to hold over time (theover-shooting concept).In practical terms, we have seen QE have a significant weakening impact on USDand on GBP, but not on JPY. In the US, the depreciation was consistent with a shifthigher in inflation expectations (from very low levels). In the UK, GBP weaknessaround QE announcements was consistent with a shift to pricing lower real interestrates. Finally, in Japan, the lack of yen impact of the QE policy, was consistent withthe apparent lack of shift in yields (nominal or real) following the various balancesheet expansions.
Starting points matter
The bottom line from the international experience (on admittedly a very smallsample) is that starting points of expectations matter a lot.
Figure 2. Starting points for QE programs
 
Note: * Japan‟s „breakeven inflation‟ shown as 3
-5year average core CPI. Source: Nomura.
 
In the US the QE policy was initiated when inflation expectations (implied in themarket) were as low as 0.2% over a 10-year horizon. A part of this was amarket anomaly, due to a dislocation in TIPS markets, but a part of it was areal fear about deflation.
Relative to the Fed‟s objective
of inflation around2.0%, this left significant room to move expectations towards the objective.
 
In the UK, the QE policy was initiated with inflation expectations fairly close totarget (inflation expectations derived from the inflation linked market stood at2.1% vs. the 2.5% BoE inflation target). Implied real rates were at 1.7%. Whilethat level was roughly in line with pre-crisis averages, it was probably highrelative to the fundamental (very weak) backdrop, leaving room for ameaningful decline.
 
In Japan, the nominal yields were at 1.1% for the 10Y when QE was initiated in2001. It is hard to ascertain with confidence what market expectations for
Nominal Rate (10Y)Real Rate (10Y)Breakeven Inflation (10Y)Actual Core Inflation
Japan QE 3/19/2001 1.1 1.1 0.0* -0.9UK QE 2/11/2009 3.9 1.7 2.1 1.6US QE-I 11/25/2008 3.3 3.1 0.2 2.0US Now 9/22/2010 2.5 0.7 1.9 0.9
 
Nomura| FX Insights September 22, 20103
inflation and real rates were at the time (given absence of inflation linkedmarkets). But 10Y inflation expectations are likely to have been in the region0% at the time (consistent with the average inflation rate in the years ahead ofwhen QE was initiated). This would then imply ex-ante real rates of around 1%,which possibly left only limited room for a further decline.
Conclusion
The experience from QE-1
showed a clear USD weakening impact from the Fed‟s
asset purchases. However, the international experience is more mixed: t
he UK‟s
QE policy in 2009 did provide a weakening impulse for GBP, although not as largeas the impact of QE-1 on the dollar. Moreover, the Japanese QE experimentstarting in 2001 did not have any detectable impact on the yen.Whether renewed QE in the US will trigger USD depreciation is likely to depend onthe impact QE has on inflation expectations and implied real rates. Importantly, the
Fed‟s ability to move these parameters depends on the s
tarting point forexpectations.Currently, 10Y breakeven inflation is priced at 1.8%
not far
from the Fed‟s
objective of 2% and very different from the implied level of 0.3% when QE-1 started.Implied 10Y real rates are around 0.9% at the moment. For this parameter, the Feddoes not have a particular objective, and it would probably like to see rates as lowas possible at this juncture to provide maximum stimulus. However, from a startingpoint of 0.9% (already an all-time low), it will not be easy to generate a largeadditional decline.It is against this background that one should think about the potential impactrenewed QE may have on the USD. Our strategy around QE-2 will be to stay shortUSD into key announcements and stick to realistic and not overly ambitious targetsin terms of how far the dollar will decline. At this juncture, this strategy suggeststhat short USD exposure is attractive into the November 3 FOMC meeting, atwhich time we expect QE-2 to be initiated. We note that there may be potential forthe market to react excessively to QE announcements given the very large impactQE-1 announcements had on the dollar. Such overshooting may presentopportunities to take profit on USD shorts at attractive levels during November-December. But at this point we are in the early phase of the USD weakening move,and the focus should be on getting the right amount of exposure. We currentlyhave short USD exposure versus GBP and are looking for opportunities to broadenthat exposure to other crosses.

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