Do not expect QE3 to sink the dollar

Recently, financial markets have been rife with speculation that the Fed would imminently signal, or engage in, QE3. Unlike the announcement of QE2 - which Fed chairman Ben Bernanke announced in a speech on August 27, 2010, at the Kansas City Fed's annual Jackson Hole retreat - there has been no clear indication from the chairman that the Fed is imminently about to engage in QE. Consequently, it is a subjective assessment as to when expectations of QE3 emerged, impacting the USD.

The June 20 and August 1 Federal Open Market Committee (FOMC) statements provided ample fuel for speculation, with the June 20 FOMC stating: "The committee is prepared to take further action as appropriate to promote stronger economic recovery and sustained improvement in labour market conditions in a context of price stability."

The Fed's August 1 statement went slightly further in stating that the Fed would "provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labour market conditions in the context of price stability."

For the purposes of our analysis, we make no subjective assessment of the likely probability of QE3, but we assume that speculation surrounding possible QE has occurred and commenced around June 20, 2012.

There is a widespread misconception that QE involves an expansion of the money supply, is inflationary, and therefore negative for the value of the USD. Rather, the Fed's QE programme is effectively sterilized intervention.

The Fed purchases US government securities from primary dealers in exchange for short-term notes - both the asset and liability sides of the Fed's balance sheet expand.

Mark Gertler and Peter Karadi (see A framework for analyzing large-scale asset purchases as a monetary policy tool, March 2012) provide us an analytical framework for thinking about the impact of QE. As with conventional policy, QE impacts the rate of inflation and economic activity by reducing credit costs. The primary transmission mechanism of QE to the USD is via a reduction in interest-rate term premia, boosting the discounted value of future earnings, and therefore equity prices, lowering asset market volatility and leading to a portfolio rebalancing effect away from USD assets (ie by reducing flight-to-quality demand for USD-denominated assets).

To quantify the potential impact of QE3 on the USD, we employ a five-country USD index comprising CAD, CNY, EUR, JPY and MXN. This index provides us a much better read on the broad USD index than does the widely followed DXY index. We employ a small econometric model for the USD index based on five inputs: 1) US-rest of world (RoW) interest-rate differentials (one-year IRS); 2) the S&P 500 index of equity market volatility (VIX); 3) spot gold prices; 4) Bloomberg index of base metal prices; and: 5) the Commodity Research Bureau (CRB) index.

Given the unusual environment associated with QE1, we decided to focus our attention on QE2. As Bernanke effectively surprised financial markets with his August 27, 2010, address, and then implemented QE2 three months later, it provides us an interesting real-world experiment on the role played by market expectations, allowing us to split our assessment into two distinct periods: 1) the month after Bernanke's Jackson Hole address; and: 2) the month after actual implementation of QE2.

In the month after the announcement of QE2, short-term US interest rates fell and the US-RoW interest-rate differential widened. The S&P500 index rallied and asset market volatility (VIX) declined. Commodity prices strengthened across the board and the USD fell 2.9%. Interestingly, in the month after actual implementation of QE2, the pattern of asset market behaviour was quite different. The US-RoW interest-rate differential continued to widen, the VIX index continued to decline, gold and the CRB index rose but base metal prices fell and the USD strengthened 1.1%.

It is clear that expectations played a key role in transmission of QE2 to financial markets, with the key impact occurring in the month after Bernanke's Jackson Hole speech.

Assuming that the June 20 FOMC represents the starting point for building expectations of QE3, we observe a similar dynamic to the announcement of QE2 and conclude that a substantial QE3 risk premium has already been built into market prices.

US-RoW interest-rate differentials have widened as the one-year US IRS fell to 43 basis points, just 8bp above its post-2008 trough. The VIX index of equity volatility has collapsed from 24% on June 20, to sub-14% today, its lowest level since mid-2007.

The CRB index has rallied, boosted by energy and agricultural commodities. Gold prices have risen modestly, while base-metal prices have stabilized. Unsurprisingly, our five-country USD index has fallen 1.4% since June 20. The behaviour of the USD and inputs into our model are consistent with market behaviour post-Jackson Hole 2010, and the emergence of a QE3 risk premium.

Again, leaning on our model for guidance, with the one-year US IRS and VIX indices already close to historical lows, two key transmission channels from QE to the USD have already adjusted, and are unlikely to place additional pressure on the USD.

Given weakness in global growth and inflationary pressures, it is hard to imagine higher global interest rates, constraining adjustment in US-RoW interest-rate differentials. Finally, the emergence of excess supply conditions in emerging Asia will continue to weigh on gold and base metal prices, limiting their likely reaction to QE3. While it is possible that the USD might weaken further, our analysis suggests that actual implementation of QE3 is not necessarily negative for the USD, as a QE3 risk premium has been built into market prices.

Furthermore, key transmission channels from QE to the USD have limited scope for adjustment. Those expecting a substantial fall in the USD in the event of QE3 are likely to be disappointed and, conversely, should US data surprise on the positive side, a decline in the QE3 risk premia could provide the USD with considerable support.

Peter is Principal of Redward Associates, a research consultancy focussed on economies and currencies in the Asia-Pacific region. Prior to founding Redward Associates, Peter was Head of EM Asia research at Barclays in Singapore.