Currencies | Jun 17 2013
– Some US dollar strength expected from Fed tapering
– Most strength expected on later Fed rate rise
– Aussie, Kiwi among most vulnerable currencies
By Greg Peel
On Wednesday night the US Federal Reserve will release its latest monetary policy statement and chairman Ben Bernanke will hold a press conference. Ever since the Fed initiated quantitative easing in 2009, Fed statements and press conferences have been highly anticipated and lead-in speculation heated to the point of causing market volatility. Given the level of debate and rumour leading into this, otherwise regular, policy statement, one might argue this statement has sparked the most furious speculation to date.
Which says a lot, given long speculative lead-in times to QE2, Operation Twist and QE3. But whereas past speculation has been all about the Fed increasing monetary stimulus, for the first time since the GFC speculation ahead of this policy meeting has been all about stimulus reduction, or the “tapering” of bond purchases. The Fed sowed the seed of taper potential in its last policy statement and the world has been in a frenzy ever since.
As Danske Bank points out, tapering does not equal QE exit, but rather an easing off on the stimulus accelerator. While Danske believes a tapering announcement will be positive for the US dollar, the economists do not expect a significant dollar re-rating until the Fed makes its first funds rate increase since the GFC. As to whether the Fed will begin to taper depends specifically on US jobs growth rather than the rate of unemployment per se, although clearly both are connected. The Fed has hinted that were the current rate of US jobs growth – 212,000 jobs per month over the past three months – to be sustained then tapering could be triggered by September.
A September commencement would be at the very early end of expectation, Danske notes. But rather than wasting time discussing timing, the economists believe it’s time to start looking at the implications of a taper that will one day come.
While much attention is focused on the US ten-year bond given it is this maturity the Fed is purchasing to the tune of US$85bn per month at present, Danske points out that global exchange rates are most strongly influenced at the two-year end of the money market curve. Exchange rates are driven primarily by the two-year interest rate differential, or “carry”, between countries, and move on forward expectations of carry rates. The time spent by the Aussie dollar above parity to the US dollar up until recently is largely representative of such a positive carry opportunity. The subsequent pullback in the Aussie was triggered by US bond rates rising on Fed taper talk coinciding with another rate cut from the RBA, implying a reduction of the carry spread between the two.
If we see the Fed begin to taper in September, speculates Danske, we might expect the rate of US unemployment will fall to the Fed’s target of 6.5% by mid-2015. At that point the first post-GFC hike in the Fed funds rate, which for a long time has been inside a range of zero to 0.25%, can be anticipated. While Danske expects a positive US dollar reaction to an announcement of reduced Fed ten-year bond purchases, the economists do not expect a serious dollar uptrend to establish until the funds rate is expected to be increased, causing the front end of the money market curve to steepen.
History would suggest such timing, but then there really isn’t any sufficient historical precedent for today’s QE scenario, Danske warns. Typically, if there is a sharp sell-off in US Treasuries (rising yields) then US stock indices tend to rise in tandem. However the 2013 scenario is one in which the US economy is largely lonely in the world in showing signs of sustainable growth. In the past, strength in the US economy has tended to tie in with strength across the globe. Yet eurozone, UK and Japanese economies remain weak, particularly the eurozone, and it is not beyond possibility that any of the three increase their own monetary policy stimulus at the same time the US is reducing.
Hence on an exchange rate basis, a Fed tapering announcement may yet spark a strong initial rally in the US dollar, Danske suggests. On the other hand nevertheless, the US is still running a sizeable current account deficit (currently 3% of GDP) while the eurozone has improved to a 2% surplus and Japan is still hanging on to a 1% surplus. The US deficit should act as a dampener on US dollar strength.
It is those countries which are “capital importers”, running large current account deficits, which are most vulnerable to capital outflows as US interest rates and yields rise, notes Danske. Downside exchange rate risk is thus most pronounced for the Turkish lira (7% deficit), South African rand (6%), Australian dollar (5%) and New Zealand dollar (6%). Of the four, the Aussie and Kiwi have enjoyed the highest market risk premium given the high yields on offer from government bonds (and stocks).
That is not to say that the Swiss franc, Japanese yen and British pound won’t also be impacted by rising US yields given the Swiss National Bank has set a minimum target of the franc to the euro, the Bank of Japan is trying to deliver 2% inflation and the Bank of England may increase its own QE program when the new governor takes up office next month.
Overall, Danske Bank believes the US dollar has the potential to strengthen over the medium term if the Fed announces QE tapering, but a significant dollar uptrend is unlikely to commence until 2014 when money markets begin to anticipate the first post-GFC rate increase. It is unusual to see the dollar rise as US bond yields rise, but then the post-GFC era counts as unusual.
Danske advises that those looking to hedge against a rise in the US dollar (and subsequent fall in the Aussie) should consider 2014 hedges now.
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