The Fed Adopts QE and the USD Gets Hurt
03/23/2009 1:29 pm EST
The Fed surprised markets by announcing another massive expansion of its balance sheet by a process known as quantitative easing (QE), which is frequently referred to as “printing money.” In addition to prior asset purchasing programs, the Fed announced plans to buy an additional $750 billion of GSE mortgage-backed assets, between $100-200 billion in other government agency-backed debt, and $300 billion in US treasuries, for a total of up to $1.25 trillion. Certainly, the amounts are staggering, and indeed, the moves will result in a significant expansion of the money supply.
Why did the Fed do this now, and what are the aims of the plan? Many market analysts, myself included, expected the Fed to wait for the implementation of the TALF (term asset-backed securities lending facility), which is designed to restore consumer lending (e.g. car loans and credit cards), before deciding whether to embark on QE. So the timing of the Fed move was initially interpreted as a sign that the economy is much worse off than thought. As conspiracy theorists would say, “The Fed knows something we don't.” More likely, the Fed decided that delay posed a greater risk and that bold action now may forestall even worse deterioration in the economy. In tandem with Treasury efforts to stabilize the banking sector, the Fed is aiming to drive down consumer lending interest rates, having exhausted traditional interest rate cuts.
Buying US treasuries sends treasury prices higher and yields lower, dropping the interest rate used to set all manner of consumer and business lending, from mortgages and credit cards to working capital loans. The expectation is that lower lending rates will support consumer spending, particularly when it comes to mortgage refinancing. The move is intended to help stabilize the housing sector by allowing troubled homeowners to refinance at more affordable rates, breaking the cycle of defaults and foreclosures and leading to lower home prices, which lead to more defaults and foreclosures. More solvent homeowners may also take advantage of lower rates to refinance, generating monthly savings that may translate into higher personal spending. In short, the hope is that lower borrowing costs will generate higher consumption.
The reality is a tad more complicated. Just because banks and financial firms may be more willing to lend and borrowing costs may fall does not mean that consumer borrowing demand will materialize. Many homeowners are under water or otherwise unable to refinance, and many households are still retrenching from prior excessive debt levels. But the Fed/Treasury efforts are addressing the only two elements of the credit equation which they can directly influence: the cost and availability of credit. The demand side of the equation will depend on how consumers respond, which remains uncertain. In short, the Fed's QE amounts to a massive effort at providing an environment supportive of future consumption, which provides more than a glimmer of hope of arresting the current downturn.
The effects on the USD have been decidedly negative, at least in the short run. As I'll suggest shortly though, QE need not be a death knell for the greenback. The USD was sold on the proposition that a massive increase in the money supply lessens the value of every dollar out there. That supply-demand logic works in the case of hard commodities, but does not look as solid in currencies, which are relative value instruments. When you sell USD, you're buying some other currency, and at the moment, alternatives to the USD are not especially appealing. Also, part of the extreme USD decline stems from the surprise element of the announcement. While the Fed had telegraphed that it may undertake treasury buying after its December meeting, the timing still caught many off guard, as I suggested above. In cases of surprise information flows hitting the market, excessive reactions are the norm. Once cooler heads prevail and the information is better digested, the initial reaction is frequently reversed. However, the risk in the current situation is that many institutional investors were caught flat-footed and are still overly long USD, potentially leading to a more drawn out USD selling phase.
Why the USD May Not Fall Much More
Much of the financial media is hurriedly writing the obituary of the USD, with some declaring its reserve currency status as dead. In reality, though, the Fed has simply followed the lead of the BOE, BOJ, and SNB, all of which have already embarked on QE. For what it's worth, relative to GDP, the BOJ is pursuing an even larger program of government debt purchases than the Fed. And yet the USD weakened against these currencies. The relative value argument suggests that if all these countries are printing money to roughly the same extent, their relative exchange rates should not be severely affected. Here the relative value argument might have some merit, except that those that have not yet done QE, namely the ECB, are likely to head down that road soon. Bundesbank president Weber today said as much when he noted that interest rate cuts alone will not end the financial crisis, implicitly referring to “unconventional easing,” which is ECB speak for QE. There appears to be a philosophical opposition within the ECB to cutting rates below 1%, suggesting their next rate cut to 1.00% on April 2 may be accompanied by a QE announcement.
On the relative growth outlook basis, the potential stimulatory effects of QE on the US housing sector and consumption in general point to an earlier US recovery than otherwise might happen. In comparison, the outlook for Europe, Japan, and the UK continues to deteriorate. On the interest rate front, the Fed's QE easing announcement saw the yield differential to other government benchmark bonds move about 50 bps against the USD, equivalent to a surprise 50 bp rate cut, for example. Such a move in yield differentials roughly translates to about a 4.5% - 5.5% move in currency values, which is how much the USD fell last week. But those yield differentials have already begun to narrow back in favor of the USD, and if markets begin pricing in QE in the euro zone, the differential will narrow further in favor of the USD.
Lastly, the sharp drop in the USD sent commodity prices soaring. Extreme USD weakness can lead to runaway commodity prices, as we experienced in the 1H 2008. The net result of that was a sharp drop in personal consumption, which tipped the US into recession by 4Q 2008. Policymakers have hopefully learned that lesson, though you can never be sure. What I'm suggesting here is that the Treasury and Fed, having thrown everything they can at the current crisis, are very likely to intervene to prevent the USD from weakening significantly further. It would be pointless to provide so much economic stimulus only to have a falling USD drive up commodity prices and have food and energy inflation erase any boost to non-basic personal consumption. In addition, the ECB certainly does not want to see the EUR appreciate significantly, while the UK has lauded a weaker GBP, as have Australia and NZ with their currencies. And Japan never minds a weaker JPY. As such, a strong case exists for coordinated G7 intervention to support the USD. The trouble with intervention is that events usually have to reach an extreme before intervention happens, but I'm optimistic a new age of global coordination and proactive policy may see a response sooner than later.
On balance, then, I do not expect to see the current USD slump continue, and I remain exceptionally cautious on the commodity rally. The global recession is ongoing, and commodity demand has not miraculously detached from the global outlook. In fact, the Baltic dry bulk index, a proxy for global trade, has fallen for the last seven sessions in a row, suggesting newfound pessimism on the global outlook, not the other way around.
Friday saw a number of significant short-term reversal patterns in many of the USD pairs. EUR/USD made a potential double top at 1.3730/40; GBP/USD made a similar double top at 1.4590/00; USD/JPY held key trend line support and the 100-day moving average at 93.40/50; USD/CHF made a possible double bottom at 1.1150/60. From the Ichimoku charts, the USD index tested below the bottom of its Ichimoku cloud, only to close above and bounce on Friday. EUR/USD made the equivalent test above its cloud, and even managed to close above it on Thursday, only to drop back into the cloud on Friday, a potential rejection signal. Having argued that the USD was set to weaken on improving risk sentiment since late February, I'm now prepared to reverse and look to use current extreme USD weakness to position for a rebound in the buck.
By Brian Dolan, chief currency strategist, Forex.com