DGAP-News: Silvia Quandt&Cie. AG, Merchant&Investment Banking: In between the lines 07.10.2010
(firmenpresse) - Silvia Quandt&Cie. AG, Merchant&Investment Banking / Key word(s): Miscellaneous
07.10.2010 16:34
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Silvia Quandt Research GmbH
Bernhard Eschweiler
eschweiler(at)silviaquandt.de
+49 69 95 92 90 93 51
www.silviaquandt.de
In between the lines
- Markets worry about Dollar meltdown as Fed prepares new quantitative
easing
- But how many new dollars will find their way into FX markets is unclear
- Euro is also not out of the woods
- Fed easing is good news for Emerging Markets assets and currencies
Not too long ago, when the sovereign crisis in Europe came to its climax,
currency markets were full of Euro doomsday scenarios, ranging from USD/EUR
below parity to a collapse of the Euro system altogether. What a
difference a few months can make! After dropping briefly below USD 1.20 in
early June, the Euro has recovered 17% and many strategists forecast new
USD/EUR highs. What has changed? Europe's sovereign debt problems seem
largely forgotten, at least in currency markets. Instead, the prospect of
a second round of quantitative easing in the US dominates markets.
Silvia Quandt believes the hype is overdone. The market may not yet have
fully adjusted positions, but a dollar collapse seems not imminent. Most
importantly, it is not clear whether quantitative easing by the Fed will
inevitably lead to an oversupply of Dollars in currency markets. Second,
Europe's sovereign debt problems may be ignored, but are not solved.
Indeed, the risk is that the next series of bad news will come from Europe
and turn the table to the advantage of the Dollar.
Quantitative easing and exchange rates
Conventional wisdom says that quantitative monetary easing must lead to
more currency supply and, thus, exchange rate depreciation. This is
correct under normal circumstances. But times are not normal. A good
example is Japan. Since the first introduction of the zero interest rate
policy in early 1999 and several rounds of quantitative easing (the latest
was announced only two days ago) the Yen appreciated 42% against the Dollar
and 27% in trade-weighted terms. A look at the monetary transmission
mechanisms helps
understand why quantitative easing may not lead to currency depreciation.
The first mechanism is the so-called monetary approach, which is based on
the role of exchange rates in trade, purchasing power parity and the money
demand function. The monetary approach says that an increase in money
supply leads to higher inflation, which in turn undermines the value of the
currency. In short, quantitative easing under the monetary approach only
leads to a weaker currency, if the easing is successful in stimulating
domestic demand. This was and still is not the case in Japan and may not
work elsewhere. Why may the 'helicopter' not do its job?
- First, banks are impaired or unsettled and fail to hand the money to
the broader public. Instead, they hold more cash or buy more
government bonds.
- Second, even if the banks pass on the money, the public is not willing
to spend more (either for precautionary reasons or due to financial
problems).
Both explanations apply to the Japanese experience and may well also
undermine the Fed's efforts to stimulate the economy. While some banks
have recovered, theUS banking system as a whole is still fragile. The
banking sector has to go through more balance sheet consolidation, which
reduces the effectiveness of monetary policy. Furthermore, even if banks
hand much of the stimulus to the public, the household sector is not in
shape or mood to leverage up. To the opposite, US households are more
likely to deleverage, which is rather deflationary.
Europe's problems are not solved
The second transmission mechanism goes through the capital market.
Quantitative easing is meant to lead to lower interest rates, which in turn
leads to capital outflows and a weaker currency. In the case of Japan,
this mechanism has worked partly, at least with respect to some high
interest-rate currencies such as the Australian and New Zealand Dollars.
But carry trades lost appeal as most OECD central banks adopted ultra-low
interest rates in response to the financial crisis.
Unlike the BoJ and the Fed, the ECB is less inclined to apply quantitative
easing. First, it is probably less convinced that quantitative easing
works. Second and more importantly, it views stimulating the economy as a
lower priority than maintaining price and financial stability.
Consequently, markets are more concerned when the ECB will exit the special
liquidity support and raise interest than whether it will adopt
quantitative easing. This leads many to believe that the ECB will tighten
earlier and more decisively than the Fed, which should help the Euro.
Silvia Quandt agrees with the logic, but thinks that financial and economic
circumstances in Europe will force the ECB to keep interest rates low for
longer, which could possibly include some steps in the direction of
quantitative easing.
The core problem in the Euro area remains the fragility of state finances
and the banking system. After Greece, Ireland is now in a debt trap, which
means it can no longer stop the debt accumulation. And the risk is that
Portugal and Spain may follow. The EU and the ECB have the means to keep
markets calm, but that is not a permanent solution and less likely to work
in an environment of monetary tightening. Currency markets are currently
ignoring these risks, but that can change quickly as events from last
spring have shown.
Interventions and Emerging Markets
A third mechanism by which quantitative easing can impact the exchange
rate is currency intervention. The
US is unlikely to adopt this approach, as it would undermine the reserve
currency status of the Dollar. In contrast, Japan is not afraid of using
interventions, as seen in recent weeks, but the effectiveness is limited as
every Yen spent to buy Dollars is recovered by issuing debt certificates in
the domestic market (so-called sterilized interventions).
Interventions (usually sterilized) are also the means by which most
Emerging Markets try to resist currency appreciation. The difference is
that most Emerging Markets are not desperate to use monetary policy to
boost growth. To the opposite, the problem for Emerging Markets is to
avoid overheating. This requires tighter monetary policy conditions, but
also attracts capital from low interest rate countries in the OECD. Many
Emerging Markets are not willing to tolerate the exchange rate implications
of their monetary policy choice - hence the sterilized interventions.
Still, not all Emerging Markets are resisting currency appreciation. A
good example is Thailand and pressure on China and others to relax their
exchange rate policy is also growing.
The use of interventions and the risk of currency wars is currently a top
agenda item. The Silvia Quandt view is that rounds of competitive
devaluations are unlikely. Thus, the key message for investors is that
quantitative easing by the Fed and others should have limited impact among
OECD countries and currencies, but increase the attraction of Emerging
Markets assets (bonds and stocks) as well as currencies.
Disclaimer
This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor,
and was first published 7. October 2010, Silvia Quandt Research GmbH,
Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German
Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht
(BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439
Frankfurt.
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Frankfurt am Main, 07.10.2010
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