Introduction
The Federal Reserve, at its Open Market Committee meeting this week, announced it was drastically expanding its purchases of both government and private-sector securities. In so doing, it changed the landscape for currency trading. The Dollar fell sharply against all major currencies following the announcement. Now, the question is: What does this mean for the future of the Dollar and for the other majors?
Background
In the period following the Lehman Brothers bankruptcy last September, the Dollar, the Japanese Yen and the Swiss Franc all rose against the other major currencies. It had now become evident that the economy was rapidly deteriorating (even though the National Bureau of Economic Research subsequently reported that the US economy, at least, had actually been in a recession since December 2007). Investors began looking for safe havens in which to park their cash and the above-mentioned currencies emerged as the most-favored destinations.
In normal times, the primary factors dominating short-term currency movements would be interest rate differentials. The currencies with the highest interest rates, all other factors being equal, would also turn out to be the strongest currencies.
However, when authorities began to discern the seriousness of the current recession, it was the Federal Reserve that acted the most aggressively, driving interest rates downward. Other central banks reluctantly followed the Fed’s lead. As a result, US interest rates were soon well below the levels of interest rates in the other developed countries, with the exception of Japan, where interest rates were already close to zero. In normal times, this would have driven investors and speculators out of the Dollar.
But, in looking for a safe haven, investors were more concerned in safety and the avoidance of risk. The fact that the Fed had been the leader in tackling the problems of the recession probably meant that the US would also lead the rest of the world out of the recession. In addition, US Treasury securities were the safest in the world, thereby adding to the Dollar’s allure.
The Japanese Yen actually outperformed the Dollar during this period, having already begun rising on the back of liquidation of Yen-carry trades (trades in which investors had borrowed Yen at low interest rates in order to sell the Yen and invest in other higher-yielding currencies). These trades were the first to go when financial institutions began de-leveraging in the wake of the collapse in values of other securities held by the institutions. On the assumption that Japanese institutions, and therefore the Yen itself, were less exposed to so-called "toxic assets," investors reasoned that the Yen would hold up better than most of the other majors.
The Yen strength came despite the weakness of the Japanese economy, probably the weakest of all developed economies.
The Swiss Franc benefited by virtue of its traditional role as a safe-haven currency.
This week it all changed when the Federal Reserve, having cut interest rates as far as they could, decided that additional, stronger measures were required. The Fed, along with other central banks, had already indicated that it would supplement its low-interest-rate policy with "quantitative easing": buying securities, government and otherwise, and paying for those securities with money created by the Fed. Until this past Wednesday, however, the Fed’s actual purchases of these securities had been limited. The Bank of England, on the other hand, which had also signaled it would use "Q.E.", had actively purchased UK gilt-edge bonds (’gilts").
On Wednesday, following the conclusion of the FOMC meeting, the Fed announced it would buy $300 billion worth of US government securities - Treasury notes with maturities between two and ten years - over the next six months. The Fed also said it would more than double its purchases of mortgage-backed securities - debt issued by Fannie Mae, Freddie Mac and Ginnie Mae - to $1.45 trillion.
The yield on ten-year US Treasuries immediately fell 50 basis points, to 2.50 percent. Currency traders also began selling Dollars, frightened by the inflationary implications of the Fed action. The purchases would increase the size of the Fed’s balance sheet to $3 trillion. Traders were concerned that the Fed would have difficulty selling enough securities to reduce the size of its balance sheet, once the economy began recovering and inflation resumed increasing. Following the Fed announcement, the Dollar fell 3.2 percent vs. the Euro and 2.3 percent against the Japanese Yen.
Now the question is: Have we turned a corner and are we entering a new phase in currency trading? Or, is this simply a short-term setback for the Dollar and can it soon resume its recent strength?
Outlook
Eurodollar
On March 5, the European Central Bank lowered its main financing rate by a half-percent, to 1.5 percent, its lowest level since the Euro was formed in 1999. ECB President Jean-Claude Trichet indicated more rate cuts could follow. Nevertheless, with key rates at other central banks virtually equal to zero, ECB rates remained the highest among major developed countries. Thus, traders this week bought Euros.
Euro - One-Year Chart March 20, 2009
Source: CNBC.com
European interest rates could move lower, if the ECB were so inclined. A European Union report said that the economy in the Euro region contracted by 1.5 percent in the fourth quarter, an annualized decline of more than five percent, and its biggest drop in thirteen years. The largest members of the EU recorded similar declines in the quarter: France, an annualized decline of 4.8 percent, and Germany, a drop of 8 percent (also annualized).
Europe can expect more of the same, or worse, in months to come. Germany is the EU’s largest economy and the German trade surplus fell to its lowest level in seven years in January, following a 20.7 percent decline in exports in the month. Germany’s economy is heavily export-dependent. Export volumes are forecast to decline 7.1 percent in 2009 and its GDP is projected to contract by 2.5 percent this year.
The second largest economy in the EU is France and French industrial production was down 13.8 percent in January, its largest year-on-year drop since 1991 (industrial production in the EU, as a whole, was down 10.1 percent). While France is not as dependent on exports as Germany, its exports are still projected to fall by 7.3 percent in 2009 and its economy could contract by 1.4 percent this year.
Therefore, for the short-term, we believe the Euro will appreciate vs. the Dollar, based strictly on interest-rate differentials. Longer term, however, the strength or weakness of the Euro will depend on the speed and strength of the US recovery and how well Bernanke manages resurgent inflation. In the long term, inflationary expectations will take over as the key factor governing currency trading.
British Pound
The chief economist at the Bank of England, Spencer Dale, this week expressed cautious optimism that Britain was "probably well through its recession." If he is correct, then the British Pound may have already seen its lows.
British Pound - One-Year Chart March 20, 2009
Source: CNBC.com
In its most recent forecast, however, the Bank of England forecast that UK GDP will contract 3 percent in 2009, its largest decline since the Second World War, following an annualized decline of 5.2 percent in the fourth quarter.
We would wait until the UK begins posting more positive economic numbers before going long Sterling.
Japanese Yen
The Japanese Yen continued to gain against the Dollar this week despite a gloomy economic outlook. Japan is more dependent on exports than any other developed nation. Japanese exports fell 45.7 percent in the year ending in January 2009, with the exports to the US down 53 percent, to Europe, down 47 percent, and to China, down 45 percent.
Japan recorded its first current account deficit in thirteen years in January, 172.8 billion yen ($1.75 billion). To demonstrate how far and how fast the Japanese current account has fallen, Japan had a current account surplus of 24,800 billion yen in 2007.
Japanese Yen - One-Year Chart March 20, 2009
Source: CNBC.com
Japan registered a quarterly GDP decline of 3.2 percent in the quarter ending in December and GDP is projected to fall 3.8 percent for all of 2009. It may decline more than that.
We see little further upward potential for the Yen at this point.
Swiss Franc
The Swiss National Bank last week (March 12) sold Swiss Francs in the currency markets, the first direct intervention by a major central bank since the Japanese intervened in 2004. The Franc that day fell 2.6 percent against the Euro, and 2.3 percent vs. the Dollar.
Swiss Franc - One-Year Chart March 20, 2009
Source: CNBC.com
With a target range for its own key interest rate of 0 - 0.5 percent, the Swiss were concerned that the strong Franc (as a safe-haven currency) would further cut into Swiss exports. The SNB recently lowered its own GDP forecast for 2009 to - 2.5 to - 3.0 percent, down from -0.5 to - 1.0 percent, its most recent forecast.
The Swiss intervention sparked concerns about a possible currency war. With Japanese officials also worried about the strong Japanese Yen cutting into Japanese exports, traders feared the Japanese might also begin intervening. We think such concerns are misdirected. The Swiss intervention was relatively successful because of two reasons: its shock effect, and the relative illiquidity of the Swiss Franc in international currency trading. The reason the Japanese have not intervened in currency markets since 2004 is because the intervention was ineffective then and would continue to be ineffective today. The Yen market is much more liquid than the Swiss Franc and would easily swallow up any central bank selling.
We would nevertheless stay away from the long side of the Swiss Franc because of the intervention threat.
US Dollar
We have talked extensively about US economic problems in recent weeks. We believe the economic stimulus package enacted by Congress and the Obama administration will be effective in bringing the US economy out of recession IF the Administration can fix the banks. Treasury Secretary Geithner’s rescue plan, when it was initially rolled out, left numerous questions unanswered. He is supposed to reveal his latest plan this coming week. We’ll see if he is able to quiet his critics.
Over the short-term, the aggressive easing by the Fed should keep the Dollar under pressure. On a longer-term basis, the key to the Dollar will be how well Bernanke and the Fed manage resurgent inflation. It will be a difficult job. We have already talked about the magnitude of the Fed balance sheet. On top of that will be the inflationary problems caused by the Obama budget - should it pass.
The Administration projects that the Obama budget will cause the Federal deficit to swell to 12.3 percent of GDP in 2009, from 3.2 percent in 2008 (although the Administration forecasts the deficit will shrink to 5.9 percent by 2011 and 3 percent by 2013). Total US borrowing will increase by $2.56 trillion in 2009 and $1.14 trillion in 2010. US borrowing in 2010 will total $9.5 trillion in 2010, 65 percent of GDP! These figures are based on the Administration’s growth forecasts for the next four years, rosy ones.
Should the Fed manage to keep inflation under control in the face of these forecasts, and should the US recovery be relatively strong, we can see the Dollar recovering its strength. But these are shaky assumptions.
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