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
): 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