QE2 Weighs on Dollar

In a few weeks, the US could overtake China as the world’s biggest currency manipulator. Don’t get me wrong: I’m not predicting that the US will officially enter the global currency war. However, I think that the expansion of the Federal Reserve Bank’s quantitative easing program (dubbed QE2 by investors) will exert the same negative impact on the Dollar as if the US had followed China and intervened directly in the forex markets.
For the last month or so, markets have been bracing for QE2. At this point it is seen as a near certainty, with a Reuters poll showing that all 52 analysts that were surveyed believe that is inevitable. On Friday, Ben Bernanke eliminated any remaining doubts, when he declared that, “There would appear — all else being equal — to be a case for further action.” At this point, it is only a question of scope, with markets estimates ranging from $500 Billion to $2 Trillion. That would bring the total Quantitative Easing to perhaps $3 Trillion, exceeding China’s $2.65 Trillion foreign exchange reserves, and earning the distinction of being the largest, sustained currency intervention in the world.
The Fed is faced with the quandary that its initial Quantitative Easing Program did not significantly stimulate the economy. It brought liquidity to the credit and financial markets – spurring higher asset prices – but this didn’t translate into business and consumer spending. Thus, the Fed is planning to double down on its bet, comforted by low inflation (currently at a 50 year low) and a stable balance sheet. In other words, it feels it has nothing to lose.
Unfortunately, it’s hard to find anyone who seriously believes that QE2 will have a positive impact on the economy. Most expect that it will buoy the financial markets (commodities and stocks), but will achieve little if anything else: “The actual problem with the economy is a lack of consumer demand, not the availability of bank loans, mortgage interest rates, or large amounts of cash held by corporations. Providing more liquidity for the financial system through QE2 won’t fix consumer balance sheets or unemployment.” The Fed is hoping that higher expectations for inflation (already reflected in lower bond prices) and low yields will spur consumers and corporations into action. Of course, it is also hopeful that a cheaper Dollar will drive GDP by narrowing the trade imbalance.

At the very least, we can almost guarantee that QE2 will continue to push the Dollar down. For comparison’s sake, consider that after the Fed announced its first Quantitative Easing plan, the Dollar fell 14% against the Euro in only a couple months. This time around, it has fallen for five weeks in a row, and the Fed hasn’t even formally unveiled QE2! It has fallen 13% on a trade-weighted basis, 14% against the Euro, to parity against the Australian and Canadian Dollars, and recently touched a 15-year low against the Yen, in spite of Japan’s equally loose monetary policy.

If the Dollar continues to fall, we could see a coordinated intervention by the rest of the world. Already, many countries’ Central Banks have entered the markets to try to achieve such an outcome. Individually, their efforts will prove fruitless, since the Fed has much deeper pockets. As one commentator summarized, It’s now becoming “awfully hypocritical for American officials to label the Chinese as currency manipulators? They are, but they’re not alone.”

China Diversifies Forex Reserves

China’s foreign exchange reserves continue to surge. As of September, the total stood at $2.64 Trillion, an all-time high. However, it’s becoming abundantly clear that China is no longer content for Dollar-denominated assets to represent the cornerstone of its reserves. Instead, it has embarked on a campaign to further diversify its reserves, with important implications for the currency markets.

Despite China’s allowing the Chinese Yuan to appreciate (or perhaps because of it), hot money continues to flow in – nearly $200 Billion in the the third quarter alone. Foreign investors are taking advantage of strong investment prospects, rising interest rates, and the guarantee of a more valuable currency. In order to prevent the inflows from creating inflation and putting even more upward pressure on the RMB, the Central Bank “sterilizes” the inflows by purchasing an offsetting quantity of US Dollars and other foreign currency.
Since the Central Bank does not release precise data on the breakdown of its reserves, analysts can only guess. Estimates range from the world average of 62% to as high as 75%. At least $850 Billion (this is the official tally; due to covert buying through offshore accounts, the actual total is probably higher) of its reserves are held in US Treasury securities. It also controls a $300 Billion Investment Fund, which has made very public investments in natural resource companies around the world. The allocation of the other $1.5 Trillion is a matter of speculation.
Still, China has stated transparently that it wants to diversify its reserves into emerging market currencies, following the global shift among private investors. Investment advisers praise China for its shrewdness, in this regard: “The Chinese authorities are some of the smartest in the world. If you look at the fundamentals of a lot of these emerging markets, they are considerably better than developed markets. Who wants to be holding U.S. dollars at this stage?” However, these investments serve two other very important objectives.
The first is diplomatic/political. When China recently signed an agreement with Turkey to conduct bilateral trade in Yuan and Lira (following similar deals with Brazil and Russia), it was interpreted as an intention snub to the US, since trade is currently conducted in US Dollars. In addition, by funding projects in other emerging markets through a combination of loans investments, China is able to curry favor with host countries, as well as to help its own economy at the same time. The second is financial: by buying the currencies of trade rivals, China is able to make sure that its own currency remains undervalued. This year, it has already purchased more than $5 Billion in South Korean bonds, and perhaps $20 Billion in Japanese sovereign debt, sending the Won and the Yen skywards in the process.
China’s purchases of Greek and (soon) Italian debt serve the same function. It is seen as an ally to financially troubled countries, while its efforts help to keep the Euro buoyant, relative to the RMB. According to Chinese Premier Wen JiaBao, “China firmly supports Greece’s efforts to tackle the sovereign debt crisis and won’t cut its holdings of European bonds.”
For now, China remains deeply dependent on the US Dollar, and is still very vulnerable to a sudden depreciation it its value. For as much as it wants to diversify, the supply of Dollars and the liquidity with which they can be traded means that it will continue to hold the bulk of its reserves in Dollar-denominated assets. In addition, the Central Bank has no choice but to continue buying Dollars for as long as the RMB remains pegged to it. At some point in the distant future, the Yuan will probably float freely, and China won’t have to bother accumulating foreign exchange reserves, but that day is still far away. For as long as the peg remains in place, the Dollar’s status as global reserve currency is safe.

Fed Surprises Markets with Scope of QE2

For the last few months, and especially over the last few weeks, the financial markets have been obsessed with the rumored expansion of the Fed’s Quantitative Easing program (“QE2″). With the prospect of another $1 Trillion in newly minted money hitting the markets, investors presumptively piled into stocks, commodities, and other high-risk assets, and simultaneously sold the US Dollar in favor of higher-yielding alternatives.

On Wednesday, rumor became reality, as the Fed announced that it would expand its balance sheet by $600 Billion through purchases of long-dated Treasury securities over the next six months. While the announcement (and the accompanying holding of the Federal Funds Rate at 0%) were certainly expected, markets were slightly taken aback by its scope.
Due to conflicting testimony by members of the Fed’s Board of Governors, investors had scaled back their expectations of QE2 to perhaps $300-500 Billion. To be sure, a handful of bulls forecast as much as $1-1.5 Trillion in new money would be printed. The majority of analysts, however, New York Fed chief William Dudley’s words at face value when he warned, “I would put very little weight on what is priced into the market.” It was also rumored that the US Treasury Department was working behind the scenes to limit the size of QE2. Thus, when the news broke, traders instantly sent the Dollar down against the Euro, back below the $1.40 mark.

On the one hand, the (currency) markets can take a step back and focus instead on other issues. For example, yields on Eurozone debt have been rising recently due to continued concerns about the possibility of default, but this is not at all reflected in forex markets. During the frenzy surrounding QE2, the forex markets also completely neglected comparative growth fundamentals, which if priced into currencies, would seem to favor a rally in the Dollar.
On the other hand, I have a feeling that investors will continue to dwell on QE2. While the consensus among analysts is that it will have little impact on the economy, they must nonetheless await confirmation/negation of this belief over the next 6-12 months. In addition, all of the speculation to date over the size of QE2 has been just that – speculation. Going forward, speculators must also take reality into account, depending on how that $600 Billion is invested and the consequent impact on US inflation. If a significant proportion of is simply pumped into domestic and emerging market stocks, then the markets will have been proved right, and the Dollar will probably fall further. If, instead, a large portion of the funds are lent and invested domestically, and end up buoying consumption, then some speculators will be forced to cover their bets, and the Dollar could rally.
Unfortunately, while QE2 is largely seen as a win-win for US stocks (either it stimulates the economy and stocks rally, or it fails to stimulate the economy but some of the funds are used to foment a stock market rally anyway), the same cannot be said for the US Dollar. If QE2 is successful, then hawks will start moaning about inflation and use it as an excuse to sell the Dollar. If QE2 fails, well, then the US economy could become mired in an interminable recession, and bears will sell the Dollar in favor of emerging market currencies.

Currency War Will End in Tears

The “currency war” is heating up, and all parties are pinning their hopes on the G20 summit in South Korea. However, this is reason to believe that the meeting will fail to achieve anything in this regard, and that the cycle of “Beggar-thy-Neighbor” currency devaluations will continue.
There have been a handful of developments since the my last analysis of the currency war. First of all, more Central Banks (and hence, more currencies) are now affected. In the last week, Argentina pledged to continue its interventions into 2011, while Taiwan, and India – among other less prominent countries – have hinted towards imminent involvement.
Of greater significance was the official expansion of the Fed’s Quantitative Easing Program (QE2), which at $600 Billion, will dwarf the efforts of all other Central Banks. In fact, it’s somewhat ironic that the Fed is the only Central Bank that doesn’t see its monetary easing as a form of currency intervention when you consider its impact on the Dollar and its (inadvertent?) role in “intensifying the currency war.”  According to Chinese officials, “The continued and drastic U.S. dollar depreciation recently has led countries including Japan, South Korea and Thailand to intervene in the currency market,” while the Japanese Prime Minister recently accused the U.S. of pursuing a “weak-dollar policy.”

As of now, there is no indication that other industrialized countries will follow suit, though given concerns that QE2 “at the end of the day might be dampening the recovery of the euro area,” I think it’s too early to rule anything out. While the Bank of Japan similarly has stayed out of the market since its massive intervention in October, Finance Minister Yoshihiko Noda recently declared that, “I think the [Yen's] moves yesterday were a bit one-sided. I will continue to closely monitor these moves with great interest.”
As the war reaches a climax of sorts, everyone is waiting with baited breath to see what will come out of the G20 Summit. Unfortunately, the G20 failed to achieve anything substantive at last month’s Meeting of Finance Ministers and Central Bank Governors, and there is little reason to believe that this month’s meeting will be any different.
In addition, the G20 is not a rule-making body like the WTO or IMF, and it has no intrinsic authority to stop participating nations from devaluing their currencies. Conference host South Korea has lamely pointed out that while ” ‘There aren’t any legal obligations‘…discussion among G20 countries would produce ‘a peer-pressure kind of effect on these countries’ that violated the deal.” Not to mention that the G20 will have no effect on the weak Dollar nor on the undervalued RMB, both of which are at the root of the currency war.
It’s really just wishful thinking that countries will come to their senses and realize that currency devaluation is self-defeating. In the end, the only thing that will stop them from intervening is to accept the futility of it: “The history of capital controls is that they don’t work in controlling foreign exchange rates.” This time around will prove to be no different, “particularly with banks already said to be offering derivatives products to get around the new taxes.” The only exception is China, which is only able to prevent the rise of the RMB because of strict controls for dealing with the inflow of capital.
In short, the “wall of money” that is pouring into emerging market economies represents a force too great to be countered by individual Central Banks. The returns offered by investing in emerging markets (even ignoring currency appreciation) are so much greater than in industrialized countries that investors will not be deterred and will only work harder to find ways around them. Ironically, to the extent that controls limit the supply of capital and boost returns, they will probably drive additional capital inflows. The more successful they are, the more they will fail. And that’s something that no new currency agreement can change.

New Zealand: No Forex Intervention

Despite reaching a temporary stalemate, the currency war rages on, and individual countries continue to debate whether they should enter or watch their currencies continue to appreciate. Nowhere is that debate stronger than in New Zealand, whose Kiwi currency has fallen 37% against the US Dollar since its peak in early 2009, and over 15% since June of this year.

With most countries, the war cries are coming from the political establishment, who feel compelled to demonstrate to their constituents that they are diligently monitoring the currency war. This is largely the case in New Zealand, as Members of Parliament have argued forcefully in favor of intervention. Prime Minister John Key is a little more pragmatic: He “says his Government is concerned about the strength of our dollar, but is not convinced intervention would work…politicians who think intervention can happen without economic consequences, are fooling themselves.” Showing an astute understanding of economics, he pointed out that trying to limit the Kiwi’s appreciation would manifest itself in the form of higher inflation, higher interest rates, and/or reduced access to capital.
This is essentially the position of Alan Bollard, Governor of the Central Bank of New Zealand. He has insisted (correctly) that the New Zealand is being driven up, so much as its currency counterparts – namely the US Dollar – are being driven downward, by forces completely disconnected from New Zealand and way beyond its control. Thus, if New Zealand tried to intervene, it would quickly be overpowered (perhaps deliberately!) by speculators. Ultimately, it would end up spending lots of money in vain, and the Kiwi would continue to appreciate.
Mr. Bollard has pointed out that a stronger currency is not without its perks: such as lower (relative) prices for certain natural resources, such as oil. In addition, since New Zealand is largely a commodity economy, its producers are being compensated for an expensive currency in the form of higher prices for milk, wool, and other staple exports. While its other manufacturing operations have been punished by the expensive Kiwi, its economy is still relatively robust. Thanks to a series of tax cuts and the lowest interest rates in New Zealand history, GDP is forecast to return to trend in 2010 and 2011.

New Zealand’s concerns are understandable, and there is an argument to be made for preventing the Dollars that are printed from the Fed’s QE2 from being put to unproductive purposes in New Zealand. At the same time, New Zealand is not such an attractive target for speculators. Its benchmark interest rate, at 3%, is relatively low compared to developing countries. Its current account balance is projected to continue declining, perhaps down to -8%, which means that the net flow of capital is actually out of New Zealand. In addition, while the Kiwi has appreciated against the US Dollar, it has fallen mightily against the Australian Dollar en route to a multi-year low.
Going forward, there is reason to believe that the New Zealand Dollar will continue to appreciate against the US Dollar as a result of QE2 and a general sense of pessimism towards the US. The same is true with regard to currencies that actively intervene to prevent their currencies from appreciating. Still, I don’t think the New Zealand Dollar will reach parity – against any currency – anytime soon, and after the currency fracas subsides, it will probably trend towards its long-term average.

Chinese Yuan Will Not Be Reserve Currency?

In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.
The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”
For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.
Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”
So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.
If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.
The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

Forex Markets Look to Interest Rates for Guidance

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.
Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.
Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates – and by much – may well dictate the major trends in forex markets over the next couple years.
Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.
China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.
Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.
The European Central Bank will probably act next. Its mandate is to limit inflation – rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.

When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.