There was a swift reaction by the foreign exchange market to the news that the US had decided to pursue a policy of quantitative easing. The announcement, after the Federal Reserve’s open market committee meeting on March 18, sent the dollar into a rapid tailspin and ended a period of broad strength that had started in mid-December.
Euro/dollar soared five cents in the immediate aftermath, climbing from around 1.3000 to 1.3500; sterling was a big beneficiary and cable rose sharply from around 1.3800, where it looked extremely heavy, to around 1.4500, where it started to look rather bid.
The dollar’s sudden trend change appears to have caught many off guard. “Although we had thought that this final step towards full-on quantitative easing was desirable and ultimately necessary, it goes against the grain of recent Fed commentary and comes earlier than we had anticipated,” says Credit Suisse.
Upside targets
Derek Halpenny, European head of global currency research at Bank of Tokyo-Mitsubishi UFJ, describes the Fed’s decision as, “a game-changing event that has prompted us to bring forward the starting point for a period of dollar weakness.” He adds: “We had assumed further aggressive steps by the FOMC [Federal Open Market Committee] at the May or June meetings that along with some further signs of financial market thawing and the start of Talf [term asset-backed securities loan facility] would have heralded the beginning of a period of dollar depreciation.”
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The Fed’s decision is “a game-changing event that has prompted us to bring forward the starting point for a period of dollar weakness” Derek Halpenny, Bank of Tokyo-Mitsubishi UFJ |
According to Halpenny, the size and speed of the dollar’s fall means that Mitsubishi’s previous upside target of 1.40 for euro/dollar no longer looks aggressive and a move to 1.45 looks plausible. Credit Suisse points out that as well as the impact of lower interest rates across the yield curve, the Fed’s commencement of quantitative easing “probably involves taking foreign investors out of their treasury holdings, at least indirectly, creating a need for these investors to acquire other US assets or sell dollars. Foreigners hold 46% of Treasury debt held by the public, and foreign central banks account for at least 70% of foreign holdings.”
Whether or not the move will result in longer-term dollar weakness remains to be seen. As BNP Paribas points out, the euro’s resultant strength has not been because of any fundamental attractiveness, but purely because it is regarded as the “anti-dollar”. With much of the economic and political news flow from the eurozone and its periphery bearish, it remains to be seen how far the euro can ultimately rise. Another issue is whether or not the European Central Bank will be forced to play follow-my-leader and adopt quantitative easing because every other main central bank around the world has already done so.
“The one central bank that may increasingly pose the question – to quantitatively ease or not to quantitatively ease? – is the ECB,” says Halpenny. “A continued appreciation of the euro will intensify pressure for action… the ECB is looking isolated in its stance on monetary caution… The ECB council remains loth to conduct any form of quantitative easing and in that regard will find it difficult to fall into line with the aggressive Federal Reserve,” he argues.
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“Although speculation is mounting that the ECB will follow the example of the Bank of England and Fed in extending quantitative easing to buying government securities, our judgement is that it won’t” Laurence Mutkin, Morgan Stanley |
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For the moment, though, it looks as if the ECB cannot ignore quantitative easing. As BNP Paribas points out, it is the big theme for markets in general. “Compared with the normal interest rate setting monetary policy approach, quantitative easing is riskier… the risks in this policy should not be underestimated,” it says. The risks seem something which are very much at the forefront of the ECB’s thinking; but there may be other reasons why the bank has resisted adopting it. Three reasons
“Although speculation is mounting that the ECB will follow the example of the Bank of England and Fed in extending quantitative easing to buying government securities, our judgement is that it won’t – for three reasons,” says Laurence Mutkin, primary analyst of European interest rate strategy at Morgan Stanley in London.
Mutkin’s three points are that it is not necessary, either from the point of view of the economic outlook or from that of monetary policy traction; implementation poses more problems for the ECB than for the Bank of England or the Fed, because there is not a unitary government bond market in the euro area; and the ECB has done a lot already and rhetoric suggests a reluctance to go down this path. And it still has other options more suited to the structure of the euro area credit market and to the ECB’s institutional set-up.
However, even if these are all solid reasons, Mutkin says the “speculation that the ECB will embrace so-called ‘active quantitative easing’ probably won’t go away”. After all, the central bank has a recent history of seemingly abruptly changes of mind.
