New round of Fed, ECB monetary easing slams dollar, boost real assets
17/Sep/2012 • Currency Updates•
Although widely expected, the announcement by the Fed last week of further aggressive, open-ended monetary easing provided a dramatic boost to risk assets worldwide, and a flight from the dollar.While the ECB has also changed tack dramatically, and it is now adopting a far more constructive role in the European crisis, the effect on its currency has been the opposite: by removing the immediate risk of a euro break up, its promises of market intervention to support peripheral sovereigns actually support the common currency. The continuing lacklustre news flow regarding the US economy also weighs on the dollar.
We see significant parallels with the situation early this year. Then, the Fed delayed its expected date for raising rates until late 2014, while the ECB announced further liquidity injections via LTRO operations, and the euro bounced off its lows as a result. The rally was temporary, and we expect the pattern to repeat this time. However, we acknowledge the positive change in ECB policy and will revise our short-term forecasts for the euro higher this week. We maintain our bearish longer-term forecasts, as we think the economic damage done by austerity policies and the ECB delay in supporting peripheral sovereign states will continue to provide serious headwinds for the euro.
UK employment provided mixed signals last week. The labour market report for the second quarter was surprisingly strong: a net 236,000 jobs were created. The unemployment rate rose slightly, to 8.1%, but this was mostly due to a jump in labour force participation. However, this is very much a lagging indicator. More timely measures, like the Markit job report, are at a level consistent with a moderately shrinking job market, which supports our view that the labour market peaked in the summer, partially driven by the Olympic Games. At any rate, it seems clear that job creation is being more than matched by increases in labour supply, and therefore see for now no risk to our call for an additional round of QE at the Bank of England November meeting. Meanwhile, sterling has clearly reverted to its role as a low-beta version of the euro, rising 1.4% against the dollar but dropping about the same amount against the common currency.
A rare bout of good news out of Europe buoyed the euro against most major currencies. Positive developments took place in the political, institutional and, for once, even the macroeconomic areas. Politically, Dutch voters largely supported centrist pro-Euro parties, and rejected the challenges to the European status quo coming from both left and right. On the institutional front, the European Commission proposal to transfer banking supervision from the national to the European level was surprisingly aggressive, both in its contents and its timetable. If implemented, the ECB would be able to take over tottering European banks from as early as January of next year. Finally, macroeconomic news came out mixed rather than dismal. Industrial production surprised mildly to the upside, rising 0.5% mom saar, rather than the continued contraction forecast by consensus. A gap has thus developed between the production data, consistent with stabilization of the sector, and the much gloomier sentiment indices that point to further contraction. This moderately encouraging news were balanced by the disastrous GDP report out of Italy.
Real GDP in the second quarter declined a severe 3.3% QoQ saar. Further, weakness was widespread, affecting consumer spending, capex, and, most worrisome of all, exports, which had so far provided the only bright spot in this peripheral economy. We think that the change to a more constructive stance with regards to peripheral sovereign debt from the ECB removes the near-term tail risk of a euro break up, and will revise our forecasts accordingly, but the dismal Italian news confirm our view that the long term economic future of the European Union is far from bright, and maintain a bearish view of the euro over this long term.
The Federal Reserve meeting last Thursday was the focus of investor attention last week, and Ben Bernanke did not disappoint. While a third round of quantitative easing (so-called QE3) had widely been expected, the Chairman surprised markets with a momentous change in the way it conducts policy. First, the amount and timing of QE3 was made open ended, and will only end when the US labour market recovers sufficiently. Second, the commitment to keep policy at zero is no longer contingent on economic conditions throughout the period – the Fed has in effect “committed to be irresponsible”. This surprising level of activism from the Fed hammered the dollar, as investors revised their inflation expectations in the US higher. While the initial reaction of the market was understandable, we think that all other major central banks will be forced to follow suit and therefore think that the dollar sell off will soon be reversed.