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Forex Research - The Basics of Quantitative Easing

The Basics of Quantitative Easing

Last Updated 12/19/2008 5:46:30 PM EST (GMT +5)

EXPECTATIONS FOR UPCOMING FED MEETINGS

CURRENT US INTEREST RATE: 0.25% Traders Favor No Rate Cut in January
  1/28 Meeting 3/17 Meeting
NO CHANGE 82.0% 67.9%
CUT TO 0BP 18.0% 14.0%
INCREASE TO 50BP 0.0% 18.1%
INCREASE TO 75BP 0.0% 0.0%
** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE

US DOLLAR: THE BASICS OF QUANTITATIVE EASING

It has been an extremely volatile week in the currency market.  On Monday, the EUR/USD was trading at 1.3364 and shortly after the European open on Thursday it hit a high above 1.47.  However since then it has reversed violently to end the week back at 1.39.  This type of price action is characteristic of an illiquid market that is uncertain about how to react to the drastic measures taken by central banks around the world.  There was no US economic data released today, but there are reports that the White House has given $17B in loans to the Big 3 automakers.  The US dollar strengthened against all of the major currencies except for the Japanese Yen.  Next week is a lightened trading week with the Christmas holiday.  US economic data is therefore jammed into Tuesday and Wednesday.  We expect the final figures for third quarter GDP, housing market numbers, personal income, personal spending and durable goods next week.  The data should continue to reflect the weakness of the US economy.  

Oil Prices Hit $33 a Barrel

Oil prices have dropped to $33.87 a barrel and in retrospect, it is almost hard to believe that the price of crude was more than $140 a barrel this summer (gasoline prices were greater than $4.00 a gallon). Since those highs, oil prices have plunged more than 78 percent and gas prices are down more than 50 percent. If we discount the run up in the first half of the year, we have still seen a 55 percent drop in oil prices since January. Crude prices matter for a variety of reasons. Lower oil prices help to cushion the ever dwindling pocketbooks of US consumers. In addition, oil has a direct correlation with consumer prices. With CPI falling for 2 consecutive months, the risk of deflation is growing. Take a look at the strong correlation between the price of oil and consumer prices.  

The Basics of Quantitative Easing

Quantitative Easing (QE) are the latest buzz words in the financial markets.  It is important to become intimately comfortable with these words because they will be the catch phrase of 2009 thanks to the latest interest rate cuts by the Federal Reserve and the Bank of Japan.

What is Quantitative Easing?

Quantitative Easing is a monetary policy tool that central banks use when they run out of room to cut interest rates.  The word “Quantitative” refers to the money supply and easing money supply means to increase it.  For many people, this term is new and with good reason because it was only coined by the Bank of Japan in 2001 after they took interest rates to zero. When that happened, they obviously had no more room to cut rates, which made Quantitative Easing their Plan B. Quantitative Easing basically involves printing money to buy a variety of securities with the end goal of flooding the financial markets with cash or liquidity.  By doing so, it increases the amount of currency in circulation which reduces the value of the currency and boosts inflation.  A good way to look at this is if there were only 100 signed Babe Ruth baseball cards worth $1000 each in the world and all of a sudden another 1000 signed baseball cards were discovered, then you would expect each baseball card to now be worth a lot less.  Having more baseball cards in the market at lower prices hopefully spurs more activity in the baseball card market.  In many ways, the goal of Quantitative Easing is the same. By the flooding the market with liquidity, the central bank aims to promote lending and prevent a shortage in the future.  Of course Quantitative Easing is much more involved than baseball card trading.  

What Outcome Can Be Expected from Quantitative Easing?

Granted that Quantitative Easing has only ever been implemented once in Japan, there is not much precedent. However with that in mind, we are sure that the Fed analyzed the outcome of Japan’s zero interest rate policy before bringing US interest rates within a whisker of Japan’s 2000 levels.   The Bank of Japan embarked upon this new concept in monetary economics in its effort to fight a frustrating period of economic stagnation and decline in 2001 which lasted until 2006.  With rates at 0% the central bank was forced to implement some new level of policy to fight the wave of deflation that had plagued the country. Deflation, another renewed catch-word in today’s economic climate, is an overall decline in prices over an extended period of time. We are all familiar with how disastrous an inflationary state can be on an economy, unfortunately deflation is no different. The cause of the phenomenon is when consumers become so resistant to spending that sellers are forced to continuously cut prices. In Japan, the BoJ accomplished their easing targets by expanding the limits as to the types of securities that they would purchase; for instance buying long-term treasuries, asset-backed securities, equities, and new levels of commercial paper. This is all in an effort to flood the financial system with so much excess reserves and liquidity that they would be forced to resume normal lending situations. In the first year of Quantitative Easing, USD/JPY fell 18.5 percent.  This means that the Japanese Yen weakened against the US dollar, which is a textbook reaction to Quantitative Easing.  The Nikkei also dropped 28 percent.  Between 2002 and the end of 2004, USD/JPY fell 22 percent as the Japanese economy began to stabilize.  During that same time the Nikkei recovered 20 percent, but not before it fell another 20 percent.  Although it has been heavily debated whether Quantitative Easing drove the turnaround in the economy, most people agree that it put a halt to deflation.   

Fed’s Version of Quantitative Easing

With US interest rates pretty much at zero, the Federal Reserve has informally adopted its own version of Quantitative Easing.  Some people may even argue that the Fed has been pursuing this strategy for months now.  In conjunction with the Treasury department, the Fed has doubled their balance sheet in the past 3 months to more than $2 trillion.  They have done this by purchasing direct equity investments in banks, easing standards on commercial paper purchases, made efforts to relieve institutions of their toxic asset-backed securities and is now considering buying Treasury bonds and agency debt.  By buying these assets, they are adding money into the financial system.  Like the Yen, Quantitative Easing exposes the US dollar to significant downside risks, but it is also the step that the central bank needs to take to stabilize the US economy and to prevent a deflationary spiral.

EUR/USD: 1,300 PIP TRADING RANGE

Of all the major currency pairs, the EUR/USD has seen the most dramatic move this past week.  The currency pair ended 550 pips higher, which is impressive in its own right but not when compared to the 1,300 pip trading range this week.  This volatility stemmed from surprising moves by the Federal Reserve and the European Central Bank.  On Tuesday, the Federal Reserve cut interest rates by 75bp, which was larger than the market expected and yesterday, the European Central Bank cut the deposit rate while boosting the emergency lending rate. These two moves had offsetting impact on the EUR/USD as the ECB reconsiders cutting interest rates in January.  Although the EUR/USD has fallen significantly, we believe that there could be a bounce in the coming week.  The Eurozone current account figures is the only piece of economic data worth watching and given the improvement in the trade balance during the month of October, we could actually see stronger numbers.  

GBP/USD: SECOND DAY OF BETTER DATA

Despite the significant volatility in the currency market, the British pound remains very weak.  Since the beginning of the month, the currency has fallen close to 13 percent against the Euro and remains not far from its 6 year lows against the US dollar.  For the second day in a row, the UK has reported better than expected economic data.  Yesterday it was Retail Sales; today it is a surprise boost in consumer confidence. The GfK Consumer Confidence Survey rose to -33, surpassing estimates that the number would fall to -39. Even though the figure is still severely depressed when compared to figures released only a year ago, any positive news is warmly accepted. Declines in energy prices and reductions in sales taxes are most likely the culprits for this development. Reports also showed that Total Business Investment was much better than expected on a year-over-year basis. However, we are still waiting to see if any of this news reflects itself in GBP/USD which keeps barreling downwards. Although next week’s holiday limits the amount of new economic releases, the UK will be releasing GDP and the Current Account on Tuesday.

USD/CAD: CPI HITS THE UPPER-END OF BoC TOLERABLE INFLATION RANGE

The Canadian dollar did not escape today’s volatility in the currency market despite the offsetting factors of stronger consumer prices and lower oil prices.  On a monthly basis, CPI fell -0.3 percent, much less than the market’s -0.8 percent forecast.  However, the Bank of Canada’s preferred inflation barometer is annualized core CPI which rose to 2.4 percent from 1.7 percent in October. This figure is now hitting the upper portion of the BoC’s acceptable inflation range, indicating some pressure on the degree of future rate cuts. The jump is largely associated with higher food prices and the result of a weakening currency. Surprisingly, the possibility for scaled-back BoC monetary easing has translated into dollar gains. Any additional news from the region will have to wait until Wednesday’s release of the monthly GDP figure. AUD/USD and NZD/USD are also under pressure today. New Zealand Credit Card spending was decisively lower, declining to -7% after last month’s 1.2%. Economic data for next week is sparse, except for NZD Current Account on Sunday and GDP for Monday. Monday’s GDP figure will be crucial in validating the expectations for a quick New Zealand recovery.  In addition, Australia will release the Conference Board Leading Index on Monday.

USD/JPY: BANK OF JAPAN CUTS INTEREST RATES TO 0.1%

For the second time this year, the Bank of Japan has cut interest rates.  This time they have brought rates from 0.3 to 0.1 percent, the lowest level since they abandoned their zero interest rate policy in 2006.  As we mentioned in yesterday’s Daily Currency Focus, the rapid appreciation of the Japanese Yen may encourage the BoJ to cut interest rates.  Physical intervention in the currency market is not usually effective and may actually be counterproductive.  Now that interest rates are practically at zero, the Bank of Japan is expected to adopt quantitative easing like initiatives once again.  The 20bp cut is only the first of the QE-like initiatives that the BoJ procured during its last meeting. In addition to the cut, the bank announced that they will be increasing the purchase of long-term Japanese bonds, easing the standards to which they buy JGB’s, and bumping up Commercial Paper purchases. These are all initiatives the bank took when they essentially founded the technique in 2001. As for the central bank’s next steps in the process, we could soon learn that they will begin purchasing equity shares in commercial banks and further expanding its bond purchases. Hopefully, through its experience, the BoJ will tweak their technique in an effort to restore economic conditions over a broader timeframe.

NZD/USD: Currency in Play for Next 24 Hours

The NZD/USD will be the currency in play on Monday. New Zealand will be reporting its Current Account Balance at 4:45 pm ET or 21:45 GMT and Westpac Consumer Confidence at 8:00 pm ET or 1:00 GMT.

Even after today’s downward pressure in the pair, NZD/USD is still holding itself within the Bollinger band buy zone. Support is being tested as we speak at the 0.5745 level, or the 38.2% retracement from the December 5th lows to yesterday’s highs. Price action is currently sitting at this level after failing to convincingly break earlier today. It is also important to note that the one-standard deviation Bollinger band lying below will be the next support area. For resistance, it is clear that the most immediate level is yesterday’s high. Before reversing, yesterday’s rallies were unable to break the 0.6081 level, which corresponds with highs placed in early November. However, if the 0.5745 level manages to retain its significance, it is possible, barring any unforeseen disastrous turn of events, kiwi could manage to retest yesterday’s highs.

About The Author

Lien has extensive knowledge within the interbank market, particularly in trading spot FX and options. She has written for numerous publications, is frequently quoted on financial media outlets, and is the author of several books, including Millionaire Traders. Read more >>

DISCLAIMER: This forum and the information provided here should not be relied upon as a substitute for extensive independent research before making your investment decisions. Global Forex Trading is merely providing this column for your general information. This forum and its information does not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision based upon this forum or any information contained within. In addition, any projections or views of the market provided by the author may not prove to be accurate. Global Forex Trading and Kathy Lien will not be responsible for any losses incurred on investments made by readers and clients as a result of any information contained in this column. Global Forex Trading and Kathy Lien do not render investment, legal, accounting, tax or other professional advice. If such advice is sought, or other expert assistance is required, the services of a competent professional should be sought.

 

 

 

 

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