Fed Tapering and the Dollar
August 22, 2013
Federal Reserve officials believe that the size of its balance sheet, not the incremental rate of asset purchases, reflects its monetary policy stance and maintain that a planned gradual tapering down of monthly asset purchases is not a tightening of policy. Results over the past 3-1/2 months support a different conception favored by many private sector economists, including myself. Details of a third round of quantitative easing were introduced last September 13. The ten-year Treasury yield was 1.73% on Sept 13, and it averaged 1.79% between that date and May 2, 2013 when the yield bottomed at 1.63%. The yield rose to 2.49%, when Chairman Bernanke in testimony effectively validated mounting market expectations that QE3’s size will be gradually trimmed between September 2013 and mid-2014. The uptrend proceeded to 2.60% by the end of July when the FOMC last met and to 2.91% today. This market behavior prompts the following three conclusions.
- A shift in the size of asset buying, that is applying less forceful stimulus, tightens monetary conditions. Quantitative easing is a way when short-term interest rates are at zero to apply more stimulus through a mechanism intended to depress long-term interest rates. The litmus test of whether less QE is stimulative, restrictive, or neutral with respect to the Fed’s policy stance is seen in the effect of the change on long-term interest rates. A meaningful 79% jump in the 10-year Treasury yield from 1.63% to 2.91% settles this question.
- One of the mantras of financial market traders is “sell or buy the rumor, and do the reverse when rumor becomes fact.” The virtual reality of QE3 as a stimulatory monetary policy tool effectively died when Fed official comments and press reports about a shifting policy predisposition at the Fed first surfaced as a way of preparing market players to anticipate tapering. That’s when long-term interest rates bottomed. Almost four months later, the FOMC still hasn’t changed it’s $85 billion per month pace of asset buying.
- Markets exaggerate. The 1.63% 10-year Treasury yield was historically and extraordinarily low. At 2.91%, the yield is not only far above the level of 1.73% when QE3 details were unveiled eleven months ago but also higher than the level when the second round of quantitative easing was launched (2.58%), the level at the start of QE1 (2.26%) and the 2.83% mean from the beginning of 2008 through May 2 of this year.
The effect on the U.S. dollar of Fed monetary tightening has not been homogeneous. A circumstance in which a central bank tightens in response to domestic economic changes is generally considered to be currency-supportive, especially when the motive for doing so is not the containment of already excessive inflation. In the event, the dollar has recorded strong recent gains against a number of emerging market currencies like the Brazilian real, Indonesian rupiah, South African rand, and Indian rupee, which hit a record low today. For the several preceding years when U.S. asset returns were paltry, these markets lured yield-seeking funds. The specter of a reversal in Fed policy has not merely turned off this spigot but reversed the directionality of the flow. These instances are a special case that reflects investor fears about holding such assets more than a growing appetite for what U.S. assets can offer.
Commodity-sensitive well-established currencies like the loonie, kiwi and Aussie dollar also have sunk sharply. Since May 2, the U.S. currency has climbed by 4.3%, 8.2% and 13.5% against these three. In each case, central bank officials have complained that their currencies are stronger than fundamentals warrant and/or outlined economic challenges posed by foreign exchange values. Investors have no fear of policy counter-action against the depreciation of these monies.
A 2.4% rise of the euro against the dollar since May 2 seems counter-intuitive if one only looks at monetary policy stances at the Fed and European Central Bank. To be sure, the rise of U.S. long-term rates has boosted European interest rates, too, but monetary policy risk in the euro area remains skewed toward more ease, not a stance reversal as is happening across the Atlantic. Euroland 3Q GDP will probably break a string of quarterly contractions, but the economy remains enormously weak and fragile with a jobless rate of over 12%, unlike America’s sub-8%. Even stranger, the dollar is 0.7% firmer against the yen compared to May 2. Japan’s economy is performing much better than Euroland’s, and its long-term rates have risen much less than European ones. Since the first quarter, no central bank’s monetary policy has been loosened more sharply than the BOJ’s. Sterling and the Swiss franc, like the euro, are stronger than the dollar now than on May 2 but to a lesser degree than the European common currency.
The dollar’s failure to appreciate across the board against the backdrop of tightening Fed policy is not unprecedented. The dollar struggled in 1994, a year when Fed policy also shifted in the direction of less accommodation and when long-term U.S. interest rates rose considerably more sharply than short-dated rates. A closer look at currency responses to monetary policy changes reveals that it helps considerably when tightening is broadly considered appropriate by the public and market, and that’s not the current case.
When QE3 was imposed a year ago, the Fed was projecting inflation of 1.8% in 2013 and 2014 followed by 1.9% in 2015. It’s forecasts for all three years, but especially 2013, are now each lower. Projected unemployment doesn’t reach 6.0% until 2015. Real GDP climbed at an anemic 1.0% annualized rate over the three quarters to 2Q13, less than a third as much as the 3.2% pace in the three months to 2Q12 that preceded imposition of QE3 in the first place. There is widespread distrust of the true motives behind Fed tapering and uncertainty created by the politicization of the choice of Bernanke’s successor. The Chairman’s absence from the Jackson Hole Symposium this weekend seems out of place, and his car accelerator metaphor to explain why tapering shouldn’t be considered a form of tightening belies common sense. Most investors have driven an automobile or at least ridden in one. When driving on level ground, an application of less pressure on the gas pedal is clearly one way to slow the vehicle. Likewise, a reduction of quantitative stimulus is a way to slow economic growth, abstracting from the fact that a much longer lag exists between central bank action and economic response than between driver action and car speed.
Copyright 2013, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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