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Post Tail Risk World Watch Balance Sheet Growth Race, ECB losing and EUR losing FX War

Post Tail Risk World Watch Balance Sheet Growth Race, ECB losing and EUR losing FX War

 

The Euro Zone crisis may not have fully ended (hints of risk in Spanish bond yields in the last few days), but it has been successfully contained. As such the key fuel for a risk on risk off narrative that has been the dominate feature of trading in all asset classes since before the failure of Lehman is no longer in the driver’s seat.

 

But that does not mean old fashion fundamentals are now steering markets, especially in DM (developed markets) FX – buy currencies where fundamentals are strong and sell them where they are weak.

 

While we may get there eventually, for the foreseeable future the path ahead is surely the central bank balance sheet race. With the BOJ and Fed in expansion mode, the BOE on hold and the ECB in shrinking mode (hence the run up in Euribor rates) the ECB is winning and the euro is losing the FX war, today’s correction vs USD notwithstanding (off 14-month high vs USD hit Friday).

 

Simply put the BOJ is leading the balance sheet growth race hands down – growth as share of GDP (see attached chart from Thomson Reuters) – and the yen is the weakest DM currency, easily winning the DM FX war. Prime Minister Abe has succeeded in driving the BOJ into a heavy lifting QE-role to achieve a 2% CPI target. While the BOJ is showing some caution on when to begin to hit the QE levers hard, there is sure to be an even greater urgency to monetize when the new BOJ Governor takes over for outgoing Governor Shirakawa in April (Abe selects the BOJ Governor and also names two Deputy Governors in March to replace retiring officials).

 

The Fed is not far behind in the footrace to grow the balance sheet and as last week’s FOMC meeting showed, there is nothing on the horizon to suggest an early winding up of QE expansion. If anything the stumbling in Q4 GDP, observation by the FOMC the economy has paused (albeit temporarily behind government spending reflecting mainly Pentagon preparations for sequestration – something I doubt is allowed to occur as Congress and White House hatch a last minute deal to avoid the pain. Still the success of the policy response by the Fed is now measured in unemployment rate, not inflation, not GDP and certainly not housing and auto demand. On reducing unemployment, Fed policy has at most averted a much higher rate (counterfactual) but has failed at seriously reducing the ranks of the unemployed. While FOMC may seem to be split over when to wrap up QE (costs > benefits from hawks and costs < benefits from Doves) the reality is the FOMC reflects the Chairman’s view and is sufficiently stacked with Bernanke believers (he invented QE) to press on with the policy. Bottom line the USD should weaken more against DM FX ex-JPY.

 

The BOE is on hold regarding QE and with a leadership transition underway the notion that Governor King and the MPC would get aggressive again with QE seems unlikely – think the consensus here is that more is not necessarily low cost option against weak growth…much closer belief that QE has diminishing marginal returns. That said the tool is not in danger of being retired and even incoming BOE Governor Carney made it clear in Davos last month that central banks (engaged in QE) are not at the end of the rope on easing – can do more if needed. So GBP gets mixed score in DM FX war – up versus USD and JPY and down versus EUR.

 

Finally the ECB has made it clear with its early (weekly) window for repaying 3-year LTRO’s (low fixed rate loans to banks) that exiting unconventional (reducing its balance sheet) is the desired course for its “technical” support for the banking system. It just so happens the ECB at the January meeting dropped any reference to a rate cut which at the December meeting was supported by a majority of members on the Governing Council. So the EUR is winning the balance sheet expansion race and losing the DM FX war with a rise in the EUR.

 

Given the vulnerability of the EZ economy and serious depressionary trends in places like Spain, Greece, and Portugal, recessionary trends in Italy and France, one has to question whether the ECB confused containing tail risk in the EZ with achieving a sustainable growth trajectory in a period of radical fiscal adjustment across the EZ.. So far the rise in the EUR has been greeted with a degree of official pride – sign that the crisis has been contained if not defeated. But with a German-led EZ growth model where the export sector relies on an undervalued EUR (in German terms), the rise in the currency is not without limit. Weak fundamentals matter and should see some shift in ECB focus from the crisis or tail risk to the business cycle risk. But that I do not see this Thursday at the next GC meeting. For the time being it is safe to buy EUR on clear front runner in the central bank balance sheet race.

 

Finally balance sheet growth is not limited to DM central banks. In the EM world central banks are adding FX reserves and have been in a fairly aggressive fashion since the millennium. And more interestingly in recent months EM central banks have become more agitated by the DM FX war and falling USD which naturally prompts activist FX policy including intervention. This is a balance sheet bloater just as QE is with one exception. In theory FX intervention by EM central banks involves sterilization – offsetting money market operations so the money stock is unchanged (otherwise it would be de facto QE). So in this world of balance sheet expansion – QE once removed race contestants should not be overlooked as engaging in the currency war…it is just not nearly as powerful as monetizing which the DM world has embraced.

 

David Gilmore

FXA

 

 

 

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