The reaction to the Fed’s QE3 announcement has been a broad-based dollar sell-off, with EURUSD and the dollar index returning to levels last seen in the spring. USDJPY is down to levels last seen in February, and triggering speculation of intervention from the Japanese authorities. The Fed’s actions are bound to reinvigorate the global currency war, in which it has been a rather successful player so far. Indeed, the move would seem to make something of a mockery of US complaints about China’s currency policy.
The pressure on the dollar has come from the open-ended nature of the Fed’s plans. Pledging to buy $40 billion mortgage-backed securities a month until US labour market conditions are to the central bank’s liking could amount to hefty QE – $1.3 trillion if it keeps it up until a new rate-hike guidance kicks in around mid-2015.
Furthermore, Fed chairman Ben Bernanke made it clear the central bank has more weapons in its arsenal, promising action if the economy did not perform. That raises the spectre of more Treasury-based QE ahead.
As Deutsche Bank strategist Jim Reid observes: “In a week where we’ve seen iPhone 5, we now see QE 3. We can’t help wondering which will win the race to 10.”
As far as the dollar is concerned, the Fed would seem to be in a unique position among leading central banks, in that it can affect the value of its currency.
Monetary policy affects currencies primarily through changes in real interest rates. With nominal rates in many developed countries near zero and QE not really changing inflation expectations, monetary policy in some countries is not altering the path of exchange rates.
Steve Barrow, head of FX strategy at Standard Bank, notes that Japan has been struggling with this problem for years, while the Bank of England, which would dearly love a weaker pound, admitted this week it has not been able to find a relationship between QE and sterling. QE is simply not boosting inflation expectations enough, and hence not causing a large enough drop in real interest rates to prompt substantial currency weakness.
Fed a special case
However, not all central banks engaging in QE were created equal and not all are powerless to affect the value of their currencies.
Indeed, the Fed stands alone in being able to undermine its currency through QE.
 |
| Steve Barrow: "..the Fed's actions can have a bigger bearing on the dollar than the QE other central banks might undertake" |
Barrow says is not because the Fed might conduct QE in a different way to any other central bank, but because Fed QE has a bearing on global risk appetite.
“More QE tends to lower risk aversion and, through this, lower the dollar,” he says. “This lowering of risk aversion can be seen in the performance of assets like equities. It could also find its effect through implied volatility.”
Implied volatility is not a function of market expectations of future movement, Barrow explains, but more a function of past movements and liquidity. The latter is important because higher liquidity drives down returns, like bond yields.
Returns in the options market are the premiums option sellers receive, and the main component of the premium is implied volatility. Therefore, when liquidity increases – because of Fed QE, for example – volatility should fall.
That weakens the dollar because the US’s low-rate structure makes the dollar an attractive funding currency for the carry trade. And the carry trade performs best when implied volatility is low.
“Hence, through undertaking enough QE to lower risk aversion, the Fed’s actions can have a bigger bearing on the dollar than the QE other central banks might undertake,” says Barrow.
So the Fed has engineered dollar weakness, but weakness based on raising risk appetite and subduing volatility, and not by shifting rate differentials.
The one comfort that eurozone exporters might take as EURUSD hurtles above $1.30 is that if dollar weakness is in part-fuelled by rising risk appetite, there is still a good chance that Europe’s sovereign debt problems could re-erupt and destroy the buoyant mood.
For now, though, and as long as asset markets keep responding to the Fed’s medicine, it would be best to accede to the central bank’s wishes and leave the dollar alone.