The renewed expansion in the Federal Reserve’s balance sheet after the announcement of QE3 will re-establish the cyclical downtrend in the USD that started in early 2009, according to BCA Research, the independent provider of global investment research.
BCA says by adopting a “whatever it takes” strategy to improve US economic conditions, the Fed has effectively introduced unlimited QE.
Harvinder Kalirai, chief strategist at BCA, says Fed chairman Ben Bernanke, as a self-proclaimed student of the Great Depression, is paying heed to two lessons from the 1930s.
First is the importance of monetary expansion and currency depreciation – Bernanke has often cited the devaluation of the USD versus gold as a pivotal event in getting the US economy out of the depression.
Second, the Fed will not repeat the mistake of pre-emptively exiting from expansionary policies.
Kalirai notes that the USD, asset prices and the economy are behaving just as they did in the 1930s.
Resumption of QE will weaken USD
Source: BCA Research
“And similar to the 1930s, the unifying factor behind the three variables is monetary policy,” he says. “If US policy is sufficiently reflationary, it weakens the dollar, inflates asset prices and supports the economic recovery.”
For the past several months, BCA held only a modest pro-cyclical bias in its currency strategy, given that a broad slowdown in the global economy was under way and that policy responses had been unimpressive.
It notes the global economic outlook remains clouded, given that leading indicators have not yet turned higher, Europe still remains in recession, European Central Bank plans to solve the eurozone debt crisis are still under scrutiny and that it is too soon to declare that China’s economy has bottomed out.
“Nevertheless, we feel that the announcement from the Fed is sufficiently aggressive that we are willing to raise our risk exposure,” says Kalirai.
BCA has therefore added new trades to its currency portfolio.
First, it has opened a short USDMXN position, based on the fact that Mexico, which sends 80% of its exports to the US, will benefit from stronger demand across the border as well as from stronger commodity prices.
“Admittedly, the peso has already recovered sharply from its lows this summer,” says Kalirai. “However, positioning is not extreme yet.”
BCA has also entered a long GBPUSD trade as a lower-risk way to play for further upside in EURUSD.
Kalirai says broad weakness in the USD and diminishing tail risks in the eurozone has the potential to push EUR/USD sharply higher. However, he is not convinced that the European debt crisis has come to a definitive end.
“Given the high correlation between the currency pairs, GBPUSD should track EURUSD higher,” says Kalirai. “If the sovereign debt crisis flares up again, sterling will almost certainly follow the euro lower. However, the downside in GBPUSD should be less than EURUSD in such a scenario.”
BCA has also entered a long gold position against the USD, reasoning that holding paper dollars as the Fed keeps real interest rates negative is virtually guaranteed to be a losing proposition.
Private investors and sovereigns will turn to gold as a preserver of wealth and purchasing power, Kalirai says.
As previously reported by EuromoneyFXNews, BCA also continues to favour short USDJPY positions.
However, the firm is holding back for now from adding long positions in the AUD and NZD, instead waiting for leading indicators from China to turn positive before entering those trades.