>FX Alert – QE2 as USD end-game

A second round of QE will likely put sharp downward pressure on the USD, to some degree versus the euro and other G10 currencies, with potential for a broader USD sell-off. Foreign investors are likely to view the renewed direct intervention as indicating that the Fed’s balance sheet expansion and implicit monetization of fiscal expenditures are first line approaches to dealing with disappointing recovery prospects, rather than the exceptional measures they were meant to be initially. This could have severe implications for foreign perceptions of the quality of the US assets that they are accumulating in private and official portfolios, and
may lead them to draw the conclusion that USD weakness is less a by-product than a desired outcome of these measures.

It is hard to argue that the EUR and JPY do not share some of the same weaknesses. However, the euro zone is essentially self-financing, with private savings offsetting almost all public deficits, and fiscal deficits remaining considerable smaller than in the US. Moreover, the euro zone’s fiscal austerity provides a credible, if painful, signal of an underlying desire to reduce fiscal imbalances that so far is lacking in the US.

Even if the ECB maintains its ‘pragmatism’ on the collateral front, the reluctance to buy significant quantities of government debt signals a desire to return to orthodoxy. From a currency perspective the euro zone combination of external balance, fiscal austerity, ECB
pragmatism and reluctant sovereign buying is likely to be more attractive than the US mix of QE2, limited deficit reduction and the need to finance a growing external imbalance while offering increasingly low rates.

Buying a little government debt while austerity is put in place is ultimately more credible than buying a lot when austerity is not put in place.

We are more sympathetic to the view that the USD/JPY is close to its trough. The stronger yen is increasingly negative for growth and wealth (through the reaction of equity markets to yen strength). Japanese real interest rates are much higher than elsewhere in G3 because of deflation. This is not really a currency plus because it is impossible for investors to arb the Japanese and USD CPI against nominal interest rate differentials. It creates a headwind to growth that becomes more severe as deflation intensifies and the yen appreciates.

To be sure the major euro risk remains that the austerity and slowing global growth will slow euro zone growth to such a degree that a sovereign default occurs and has severe knock-on effects on other fiscally weak countries. That clearly remains the major euro zone risk. However, investors have tolerated prior ECB intervention well, and the ECB’s reluctant intervention to avoid the worst in sovereign debt markets has been euro positive.

Concern that monetary policy is ineffective
Recent downward surprises in housing and investment data suggest a deepening risk that the US is entering into a significant slump. Given the run of very weak data investors are now focused on the policy response, with comments by Fed and international officials at Jackson Hole the ‘payrolls’ event of this week. Central bankers are loath to admit that they may be pushing on a string, although the combination of balance sheet constraints at commercial banks, idle balances throughout the financial system and low loan demand by borrowers make this a possibility. Moreover unlike the first run at QE, neither the level of rates nor spreads point to an obvious problem that a new round of QE can solve (unless they decide to buy Greek and Irish debt). Our US Economists have stressed that “… monetary policy will need to err on the side of ease…. The [Fed] reinvestment plan likely will be enhanced by more active balance sheet expansion or perhaps new efforts to unblock credit.”

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