Quantitative easing – round two, the exit

The mechanics of round two of quantitative easing is a twofold process of strategy and tactics. The strategy is determining when to exit and the tactic is the form of the exit. Global exchange rates will revolve around five monetary players, the G-3, UK, and all of the rest. There also is a growing wild card of the IMF which may have a significant influence on the how the global monetary system takes shape in the coming years, but that discussion will not be as germane to short-term foreign exchange dynamics.

The majority of the world is in a process of normalization. Norge Bank and the RBA have begun this process. Countries have started to discuss ending their easing with rate increases as they normalize their targeting processes. With deflation fears abating and actual headline inflation inching to positive, the policy focus is again on controlling inflation within target bands. This allows for attractive monetary and growth drivers for currency appreciation and was a driver for February performance. However, it is the central bank policies of the G3 which will more decidedly determine global liquidity and currency directions.

Japanese monetary policy is a growing riddle and global outlier. The Finance Minister is calling for an end of deflation, yet there does not seem to be anyone at the BOJ who is listening. The BOJ has rejected inflation targeting which could be the objective of a new easing program. With flight to quality flows pushing yen levels back below 90, there may be growing pressure to take action. This policy need is the polar opposite of the other large QE.

The Fed has clearly laid out tactics for reducing their balance sheet, yet the combination of a large output gap, high unemployment, and a lazy V-shaped recovery continue to push any policy reversal quarters away. The wild card is the reaction to the end of the mortgage purchase program. It looks like an open check book from the Treasury for Fannie and Freddie will allow the Fed to be off the hook this month but will place more pressure on Treasury supply.

The ECB has stabilized its balance sheet over the last year, but any potential PIGS crisis may force the central bank to again step-up to provide liquidity for European financial institutions, significant holders of Greek debt. This creates more downward pressure on the euro.

The BOE is now seeing a worst case scenario of large budget deficits which do not seem controllable, slow growth, and rising inflation. This provides little room for the BOE to significantly reduce their balance sheet. The market is pricing in a further currency sell-off.

The potential for timing and sizing to be wrong during the exits means that the chances for currency dislocations are high. Directional policy errors will be manifested in directional price movements. Additionally, the currency appreciation from “safe” developed to formerly risky EM currencies will continue, albeit contained by the “stabilization” policies of EM central banks.