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What Are The Implications Of Quantitative Easing For Currency Markets?

By , Currency Strategist
01 April 2009 14:24 GMT

The G-20 Summit is set to begin on April 2nd and one of the topics of discussion will be the impact of the recent efforts of the major central banks to break the credit crunch.  The Fed, Swiss National Bank, Bank of Japan and the Bank of England, which all have limited options with their benchmark interest rates close to zero have embarked on quantitative easing. The Fed announced that it would begin buying $300 billion worth of U.S. government bonds, which was significantly more aggressive than its counterparts including a £75 billion plan from the BoE. The benefits of these actions are that we may finally see credit markets thaw, housing stabilizes and equities rebound. However, the long-term implications could be rising inflation, formation of new bubbles and the possibility of further economic decline.

 

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What is “Quantitative Easing”?

Benchmark interest rates tumbled lower around the world in recent months as central bankers scrambled to create incentives for consumers and businesses to spend and invest amid deepening recession. As borrowing costs increasingly approached 0% with no visible sight of improvement in economic activity, policymakers began to target long-term lending rates through a process called “quantitative easing” (QE). Put simply, the process works as follows:

1.    The central bank creates some predetermined amount of new money (which is can do as the steward of the money supply) and uses it to buy government bonds in the open market.
2.    Because the supply of bonds has been reduced, their price goes up. This means that the yields required to make them attractive investments are reduced.
3.    The banks that sold the bonds to the central bank now have more money on hand that they are able to lend. Because the yield on bonds is now lower, lending money to someone other than the government (i.e. individuals or businesses) at a higher rate becomes more lucrative, spurring credit access to the private sector and encouraging economic activity.

What Is The Immediate Impact?

The U.S. and U.K. economy may realize the greatest impact from their efforts as their economies aren’t as reliant on exports as the Japanese and Swiss. As they buy government bonds they will increase liquidity which should help break open credit markets and inspire consumer and business lending. Indeed, U.S. Treasury Secretary Timothy Geithner said that “To get out of this we need banks to take a chance on businesses, to take risks again.” If credit standards loosen then we may see the housing market ultimately bottom as it would fuel demand and bring an end to falling values. Additionally, the removal of toxic assets from bank’s balance sheets will help ease fears and should bring stability back to the banking system and inspire risk appetite. This was evident by the U.S. equity markets rising to the highest level in six weeks after the announcement of the U.S.’s plan. A reversal in housing and stock markets will help lift consumer confidence which has started to show improvement, evidenced by the University of Michigan survey unexpectedly rising to 57.3 from 56.6 in March. If increasing optimism inspires domestic demand then we may start to see businesses end layoffs and resume hiring.  This would be welcome news for a U.S. economy that is expected to have lost another 659,000 jobs in March, and in the U.K. which saw unemployment rise to the highest level since 1971.

How Do You Trade It?


Although, we may see both the U.S. and U.K. economies benefit from the increased liquidity and ultimately their corresponding currencies, there could be different initial reactions. The increase in risk appetite may lead to dollar weakness as the slowing of safe haven flows isn’t offset by the increase in the demand for other U.S. assets. Meanwhile, the pound could benefit from the increased demand for British assets which would support a long position.

Does QE Guarantee Inflation In the Future?

The chief concern with quantitative easing has been a fear what printing money “out of thin air” will do to inflation once global economic growth begins to rebound. Assuming the scheme works out as intended, the extra money divined by central bank will enter into circulation, making the relevant currency more abundant. As with anything made more readily accessible, the currency’s value will decline, leading to an “artificial” spike in prices. Depending on the size of the monetary injection, prices could skyrocket so dramatically as to erode a currency’s status as a store of value and effective medium of exchange, undermining economic activity altogether.

While fears of such a scenario are reasonable, it is not entirely guaranteed that it will necessarily materialize. Monetary efforts to boost access to lending have been coupled by a massive jump in government spending, with lawmakers committing billions to a wide array of projects to replace vanishing private sector demand and check the slide in economic growth. In most cases, this spending has expanded government deficits and will need to be financed by borrowing. This is set to flood the market with new government bonds, sending their prices lower and their yields higher. Higher returns can be expected to attract investors, spurring demand for whatever currency is needed to buy the bonds in question and working against the depreciative effects of QE. On balance, as long as the central bank does not print more money than is needed to finance the government’s fiscal shortfall, inflation need not be the net result.


Trading QE Regardless of the Inflation Outlook


The impact of quantitative easing on future inflation rates will determine the optimal currency trading strategy as economic growth returns:

1.    If QE creates inflation, buy AUD and NZD. Supposing the central bank’s QE efforts outpace government spending and the end result is uncomfortably high inflation, traders will look to shift capital into assets likely to retain their value. This is likely to benefit tangible goods like commodities, particularly gold because of its relative liquidity. In this case the Australian and New Zealand Dollars are likely to outperform the likes of the Japanese Yen, the British Pound and the US Dollar: commodity bloc countries have not gone down the path of quantitative easing and their currencies are closely correlated to commodity prices; further, yields on AUD and NZD are unlikely to fall too much beyond current levels, adding to their attraction versus those where short-term rates are already at or near zero.

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2.    If QE does not create inflation, buy USD. Because the US was first to respond to the current crisis with both monetary and fiscal measures, it is reasonable to suppose that it will lead in the eventual recovery. This suggests that the US Federal Reserve will lead its major counterparts in starting to raise interest rates, shifting short-term yield expectations in favor of the US Dollar. Further, the US government is almost certain to issue billions in Treasury bonds to finance the tremendous amount of deficit spending that has been undertaken to combat the crisis. The US fiscal effort dwarfs anything that has been undertaken in most other industrial economies, suggesting yields on Treasuries will see a greater boost from new debt issuance and thereby become more attractive to investors than other public debt instruments. Assuming the Fed does not print so much money as to offset the impact of this demand, this should is set to boost demand for the greenback and dollar-denominated assets at the expense of nearly other major currency.
 

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01 April 2009 14:24 GMT