QE2 and event risk

QE2 should not be subject to large event risk. The Fed has had more than enough time to tell investors what is its plan and how it will be implemented even without giving the actual amount and timing.

It is understandable that a central bank wants to have the maximum amount of flexibility to pursue its goals, but this flexibility creates uncertainty. There have been many arguments about rules versus discretion in monetary policy and this is just one more example of the problem which exist when there is maximum discretion.

While QE2 may be difficult to implement through rules, the market has no clear idea of what will be the criteria for action and what is the link between any action and the price responses. There is no clear agreement on what is the policy objective. Is it to lower all yields on the Treasury curve or only those inside 10-year maturities? It is not clear if the objective is to get credit spreads down. It is not clear how much has to be bought to affect a 10 bps change in yields. Consequently, the event risk is high and the chance of success low.

How should an investor prepare for the Nov 3 announcement. Being aggressive is not a good choice.

BOJ asset purchase program

BOJ announced this month a large program totaling 5 trillion yen of quantitative easing. What makes this different is that the BOJ will buy corporate bonds rated as low as BBB and well as second tier commercial paper. This place the BOJ more squarely in the credit purchasing arena. They will be making clear choices of which firms will get funding and which will not .They started to buy credit of higher quality last year bu this is a major move down the credit spectrum. This is not what a the lender of last resort should be doing. This is a mix of monetary policy and state intervention.

It is not clear this will work. Picking credits is not easy and not the normal role of central banks. How is this going to stop the deflation in Japan? Also, it is not clear that this size of the program will be effective since the Fed will have its own program of quantitative easing. The impact on the yen may be minimal, yet this is supposed to be one of the key roles of monetary policy.

Fed asking bond dealers about Fed intentions

Seems a little out of the ordinary when you have the Fed surveying primary government bond dealers on the Fed's intentions for asset purchases over the next six months. The survey specifically asks about initial size of program, the time over which it will be completed and how often the Fed will evaluate the program.

So the Fed will ask the dealers what action the Fed will take as a way to reduce market uncertainty? The Treasury is asking at the same time what is the level of liquidity in the market. You would think that these two issues are tied together. The quarterly refunding will come at the same time as the Fed QE2 announcement. This should be thrilling.

The initial survey suggests that there is no consensus on what the Fed will do. The bottom line is that wide expectations mean there is going to be disappointment on both the upside and downside. This is not reducing market uncertainty.

More intervention from Norway

Norges Bank selling NOK 800 mm per day versus NOK 600 mm per day in October. This is 60% of their trade balance surplus. The intervention bandwagon to control currency appreciation is not just in Asia. Everyone is worried about exchange rate regardless of what the G20 may say in communiques.

The theme of controlled appreciation will play havoc on models of exchange rate determination and ill make it that much harder to plan for future trade. There is no easy solution. The control of trade through tariffs is no better and discussions of using capital capital control are a Pandora's Box of capital flow uncertainty.

Wall of liquidity versus wall of worry

The problem with a financial crisis is that the wall of worry is very high. Keynes view is that the economy needs animal spirits to create a sense of optimism to gee over the wall of worry and continued uncertainty. The worry all can be offset by a wall of liquidity. This is the premise for QE2. A wall of liquidity will offset the worry. Excessive liquidity will allow borrowing to continue or actually overshoot the current worries in the economy. The problem may be that the wall or wave of liquidity may not be high enough to offset the worry. Or, liquidity at the other extreme could be too great.

Ultimately these walls are associated with expectations. Changing expectations is critical to increasing growth. The expectations that liquidity will be cheap is supposed to offset market worry. Unfortunately, it is difficult to control expectations. Policy markets and economists have not been able to control the thoughts of businesses and consumers.

Germans get tough with EU.

The golden rule applies - he who has the gold sets the rules.

This is what the Germans believe with their proposals to the EU to minimize the potential for future debt crises. Germany as a strong surplus country wants a permanent crisis resolution mechanism which will reduce some of uncertainty surrounding any EU sovereign debt debacle, and they want some penalties when government budget deficits are not in order. Rules for resolution which will not be passed on the immediacy of a crisis, and rules to stop crises from occurring in the first place. These may include taking away voting rights for EU countries that cannot control their budgets.

These require treaty changes in the EU and Chancellor Merkel is willing to push the debt resolution issue because the status quo will place the system at risk over the longer-run.

A change in the treaty which allows clear resolution will reduce the moral hazard problem that occurs when there is the perception that a bail-out will come. This of course has to be tied to rules that penalize bad sovereign behavior to reduce the chance of a crisis in the first place.

The desire for these types of changes is not high amount many countries because they see themselves as more likely harmed by these rule changes. As the largest creditor, Germany wants to flex its financial muscle. The alternative will cost Germany dearly. Ratifying new treaty rules will be difficult in any scenario but this is a very sensitive issue which separates German creditors against a majority of EU debtors. There are costs with political union and most do not want to pay the price.

G20 - imbalances and no consensus

The market had low expectations surrounding the G20 summit and they were realized. Of course, Treasury secretary Geithner said that he believes in a strong dollar going into the meetings. The US idea of trade imbalance guidelines was a slight surprise. It tried to change the focus away from currency wars. However, a focus on external balances and currency movements still does not address the root cause of the problem which is the savings imbalance and growth differential story between developed countries and emerging markets.

The imbalance problem, however described, will be a dollar problem. There no targets for trade imbalances which may be addressed next month. Still, there is a chance for surplus targets between the US and China. The role of the IMF is uncertain but the G20 may be moving slowly in the right direction. Of course, there is the larger issue that you cannot get agreement when you have as diverse of a group as the G20. Currency wars should continue even if the tone of the comments are dampened.

Why currency wars and not protection

This is an interesting take on why there are currency wars. Given flexible monetary policy, there is less need to resort to protectionism. However, if monetary policy is ineffective then we will see a move to capital controls and protectionism. In this case, the Fed is swamping the activities of all other central banks hence countries have to move to other policy choices. A good example is Brazil.

All-Chicago Friends of Economic History Dinner
Speaker: Douglas Irwin (Dartmouth College)

Irwin’s lectures, “Trade Policy Disaster: Lessons from the 1930s,” will be published by MIT Press in 2011 as a part of the series of Ohlin Lectures. Irwin will examine the reasons for the outbreak of protectionist trade policies during the Great Depression.

...“The main reason that countries adopted such draconian anti-trade policies in the early 1930s is that governments lacked other policy instruments with which to address the Great Depression,” Irwin says. “In particular, the gold standard prevented countries from using monetary policy to ameliorate the economic downturn. Countries that left the gold standard and allowed their currencies to depreciate not only recovered more quickly from the Depression, but did not need to restrict trade in a futile attempt to ward off the slump. Protectionism and currency depreciation were substitutes for one another, but depreciation was much better for the world economy than protectionism.

“One lesson for today is that, because most countries have independent monetary policies and flexible exchange rates, they don’t need to resort to import barriers in response to an economic crisis,” he continues.

Deficit focus - do the math

“Debt and deficits are not inventions of ideology. They are facts of arithmetic.”

– Paul Martin, Canada’s finance minister at the start of the country’s “Redemptive Decade”

taken from John Mauldin's Outside the Box e-letter

One of the most important lessons is that long-term structural deficits are not about politics but just a math problem that only has one solution. Benefits will have to be cut. You cannot make the number balance if there is no economic growth. You cannot make the numbers balance is the growth of transfers and government expenditures continue at a rate higher than the growth of the overall economy.

QE2 to QE 20 - global asset prices will rise

QE2 may well be the global driver of growth or put differently QE2 is actually QE20.

The US may be a key driver of the currency wars because it is willing to flood the global economy with dollars. Who cares if the dollar goes down. This will be better for exports which may be the driver of job creation. Who cares if there is higher inflation. The increases in asset prices will be good for all, especially home-owners who need higher real estate values. If bond holders are hurt, no problem. The higher inflation will reduce the value of nominal debt outstanding.

The rest of the world will have to inflation along with the US. They may not like it, but what can they do? If the do nothing their currencies will appreciate and they will lose export business to the US. If countries want to fix or limit their exchange rate appreciation, they will buy dollars and sell their currency which will be inflationary. The word will be in an asset price inflationary spiral. Investors should buy real assets and prepare for a wild ride.

Currency vigilantes mount up

We had the bond vigilantes in the 90's during the Clinton administration and now we have currency vigilantes during the Bernanke period who will dump a currency if the fiscal house is not in order.

The bond vigilantes were worried about rising interest rates from increases in government debt. The currency vigilante are worried about expected inflation from a rise in fiscal debt. Sovereign risk increases from the threat of debasing debt held by outside investors causes currency holders to get out of foreign exchange. We saw this action with the euro during the PIG crisis in the spring. We are now seeing this with dollar. The threat of higher inflation from QE II is causing investors to dump the dollars. The same will be seen with any other currencies which have loose monetary policy and high debt.

Talk of currency wars

Placing the currency ware rhetoric in context is hard with so many different comments. BNY has done a good job of providing in one place many of the key comments. While word are cheap relative action, the comments are starting to get more aggressive.


Commentary from BNY:

On a day that may see the US label China a currency manipulator, the following headlines – taken from our briefings over the past fortnight – shed some light on the issues and tensions that have arisen amongst members of the G20 as the countdown to their meeting in South Korea gets underway.

October 1st
Brazil’s central bank governor Henrique Meirelles tells Reuters Insider that while it might be beneficial to the US economy, a second round of quantitative easing could “accentuate (global) liquidity and overflow … We cannot simply allow our economies to be imbalanced while allowing other economies to be balanced.” Mexican deputy foreign minister and G20 ‘Sherpa’ Lourdes Aranda tells Reuters that China should not be singled out over the valuation of its currency at the G20 summit in November. She says: “What you want is to have a dialogue and not to back anyone into a corner.” She adds: “What use would (G20) be if China did not go?”

October 4th
IFR Markets estimates that the authorities in Asia bought USD 18.8 Bn through intervention last week. Separately, Bank of Korea data show that FX reserves rose to a record USD 289.78 Bn in September, up from USD 285 Bn in August.

October 5th
The Brazilian government doubled the tax due on foreigners’ purchases of local fixed-income assets to 4.0% in an effort to slow the rise of the BRL.

The South Korean authorities announce that that the BOK and the Financial Supervisory Service plans to conduct inspections of FX derivative positions at selected local and foreign banks.

Dow Jones newswires cite market reports of fresh intervention in the FX markets by the South Korean authorities. Two sources tell the newswire that they estimate the buying to have been worth around USD 1 Bn.

The Bank of Thailand’s senior director with responsibility for financial markets, Wongwatoo Potirat, says that the bank is a little worried about the THB’s continued rise and says that it is studying ways that the flow of funds can be controlled. He notes: “Imposing measures is a serious matter, and we need to study both the good and bad points to see who will win or lose."

October 6th
The FT reports that IMF chief Dominique Strauss-Kahn has warned that governments are risking a currency war if they try to use exchange rates to solve domestic problems. He said “There is clearly the idea beginning to circulate that currencies can be used as a policy weapon … Translated into action, such an idea would represent a very serious risk to the global recovery … Any such approach would have a negative and very damaging longer-run impact.”

Nobel prize winning economist Joseph Stiglitz said that “The irony is that the Fed is creating all this liquidity with the hope that it will revive the American economy … It's doing nothing for the American economy, but it's causing chaos over the rest of the world. It's a very strange policy that they are pursuing.”

China’s official Xinhua news agency reports that Premier Wen Jiabao has urged the EU to treat the issue of the CNY ‘objectively and fairly’. Wen made the remarks at the same meeting with Jean-Claude Juncker, Jean-Claude Trichet and Olli Rehn. Wen reaffirmed China would continue reforms to make the CNY more flexible.

October 8th
Russian Deputy Finance Minister Dmitry Pankin says "Exchange rates are already a result of deeper processes: the propensity to savings, investment, the investment climate in a country, level of demand." He also notes: "Free float is not an exit prescription, it's not a prescription for all illnesses."

October 11th
South Korean President Lee Myung-bak says that the G20 must agree on their foreign exchange policies by their November meeting, as a failure on policy coordination could lead to big problems for the global economy.

October 12th
The China Securities Journal says (in a front-page editorial) that quantitative easing in the US will trigger a new round of asset price rises, and that continued USD depreciation will result in higher resource prices. It notes: “The financial crisis could escalate into a currency crisis … There will be no winner.” It argues: "Therefore, the best monetary policy choice currently is surely to take no action on interest rates, and at the same time manage well the pace of CNY appreciation, avoiding the impact of a rapid appreciation on the economy."

The Thai government agrees to impose a 15% withholding tax on interest and capital gains earned by foreign investors on government bonds.

Taiwan’s Economic Daily reports that the central bank will not now allow local banks to place non-deliverable forwards orders at 11 am each day.

IFR Markets estimates that the central banks of South Korea, Malaysia, Indonesia, Thailand, the Philippines and Taiwan collectively purchased USD 32. 69 Bn between September 27th and October 11th.

October 13th
When asked about South Korea's currency intervention and its place in G20, Japanese Finance Minister Yoshihiko Noda said “As chair of the G20, South Korea's role will be seriously questioned”. He added “In South Korea, intervention happens regularly, and in China, the pace of CNY reform has been slow … Our message is that we have confirmed at the Group of Seven that emerging market countries with current account surpluses should allow their currencies to be more flexible.”

Brazilian Finance Minister Guido Mantega says (regarding the impact of the decision to double the IOF tax on foreign investment in domestic sovereign bonds): “At this moment we're waiting to see if the currency will stabilize. It's possible that it happens." He adds: "If it doesn't work this time, we will be thinking about other measures." Regarding QE in the US, he notes: “I don't think it will reactivate the economy, but it will weaken the USD."

Cui Tiankai, a deputy foreign minister and China's key G20 negotiator, says (when asked whether he is worried about a spectre of a global currency war): "We are doing our best to avoid that. But it requires efforts of all the G20 members, not China alone."

October 14th
Taiwanese Financial Supervisory Commission Chairman Chen Yuh Chang states that the government will carefully evaluate any plan to tax short-term capital flows into Taiwan because of the impact foreign investment has on the stock market.

The Monetary Authority of Singapore has widened the trading band for the SGD for the first time since 2001. MAS said the band was widened “in view of the volatility across international financial markets.”

The Bank of Korea keeps interest rates unchanged but comments in a statement that moves in the foreign exchange market “are a risk to the economy” and could affect future policy decisions, noting “That is one of the factors, although we are not taking only that into account”.

Finance minister Yoon Jeung-hyun says “With the recovery slow in the advanced countries, each country relies more on exports for growth, and tension surrounding foreign exchange rates is intensifying, and there are signs that this could develop into trade protectionism”.
China Commerce ministry spokesman Yao Jian says: "It is entirely wrong for the United States to make an issue of China's trade surplus and hence put pressure on the CNY exchange rate. The CNY should not be a scapegoat for United States' domestic economic problems. "He adds that China is a responsible country and will push ahead with currency reform based on its own domestic conditions. Yao also notes that a 3% rise in the CNY ‘would place greater pressure on exporters’ and that Japan is in ‘no position’ to criticize China’s currency policy given that Japan has had a trade surplus with China for eight years.

Curency war rhetoric gets odd

The Russian central bank’s deputy chairman said, “The Bank of Russia is not taking part in any currency wars. We are a peaceful organization and call our colleagues to peace." He adds: "A currency war is a very dangerous thing and the consequences of losing could be global.”

The ruble is one of the few currencies which is not facing significant strength; nevertheless, it is odd that Russia who has been aggressive in other political ares states that it will not take part in the currency wars.