The Federal Reserve’s recent announcement that it would pursue another round of quantitative easing as well as renewed concerns about sovereign debt in Europe have again focused investors’ attention on the currency markets. In this Q&A, FX Strategist and Portfolio Manager Ugo Lancioni provides insights into these developments and explains where he is finding value — and risk — in the current landscape.

QUANTITATIVE EASING HAS BEEN A KEY ISSUE IN THE CURRENCY MARKETS. WHAT IMPACTS HAVE YOU SEEN?

With its second round of quantitative easing, or QE2, the Fed intends to buy $600 billion in Treasury securities in an attempt to stimulate growth further and reverse the downtrend in employment by keeping ample liquidity in the market. Interestingly, the impact on the dollar since the announcement on November 3 has been muted.

This is not a big surprise. To put things in context, back in 2009, when the Fed introduced the first round of quantitative easing, QE1, the result was lower interest rates and a substantially lower dollar as yield-hungry investors moved away from U.S. assets. The timing and, to some degree, the surprise factor of the announcement of QE1 was crucial. In fact, prior to the announcement, there was little speculation about such a full-scale purchasing program. Also, at the time, the dollar was in demand as a result of flight-to-quality flows, given the uncertainty and risk aversion in the market. Hence, the impact was powerful; rates fell and the U.S. dollar depreciated.

As most people know, economic growth later picked up, but expansion was limited and employment remained a concern. With limited prospects for fiscal stimulus, Fed Chairman Ben Bernanke started to pave the way for QE2 back in August and the markets gradually discounted its expected effect over time. As a result, U.S. yields fell and the dollar weakened in anticipation of the QE2 announcement.

So, the QE2 effects had been widely expected for a while by bond and currency investors. Although the size of the purchasing program was slightly larger than anticipated, the announcement was broadly consistent with the market expectations. The dollar, although lower than in August, has since the announcement remained above the bottom of the broad trading range that has prevailed since the 2008 credit crisis and has not weakened further.

WHAT IS YOUR OUTLOOK FOR THE U.S. DOLLAR FROM HERE?
The main driver of short-term dollar price action is likely to be risk appetite and, as we have recently seen, sentiment can change frequently in an uncertain investment climate. We believe the dollar is likely to move higher on an intermediate-term basis. QE2, in our opinion, could lead to stronger economic growth in the U.S. and eventually drive higher yields, making the dollar more attractive to investors. Even if it is too early to see a clear change in trend, recent U.S. economic data have been slightly more promising, above the consensus estimates.

In our view, the impact of QE2 was already in the price of the U.S. dollar at the time of the announcement. And the market is generally still shorting dollars. Moreover, from a long-term perspective, when looking at purchasing power parity fair value measures, the dollar still appears undervalued. On average, the dollar appears approximately 15% undervalued against the other G10 currencies from this perspective. Even if growth differentials have partially been responsible, this discount is not likely to be sustained as its magnitude is fairly large from a historical perspective.

Obviously, there are pitfalls associated with our viewpoint. If U.S. growth does not pick up, the dollar may not go anywhere and could even weaken further.

AFTER THE QE2 ANNOUNCEMENT, ATTENTION MOVED QUICKLY TO EUROPEAN POLICY. WHY?
Since the beginning of the credit crisis of 2008, the global markets have largely focused on bad debt. However, speculation around QE2 attracted most of the markets’ attention after this summer.

While everyone was trying to forecast the size of QE2, the spread between debt issued by “peripheral” European countries (such as Greece, Spain, Italy and Ireland) kept widening relative to core European (e.g., German) issues. Once QE2 was out of the way, market attention returned to Europe.

CAN YOU EXPLAIN THE CURRENT ISSUES?
In the spring, as you’ll recall, uncertainty over Greece’s ability to pay its debts triggered widespread concern and contagion that affected currency markets and the yields on sovereign debt. This, in turn, had a negative effect on risk assets around the world. However, markets later recovered as investors became more comfortable with the European Union’s bailout package for Greece and fiscal reforms among various countries that were considered vulnerable.

Recently, Ireland has become the center of attention as investors have shown worry that the country — which is beset by a large debt burden and a vulnerable banking sector — will not be able to meet its financial obligations, many of which come due next year. The market has driven up the yield on Irish debt, as well as the debt of peripheral European countries. The contagion effect brought the Irish under heavy political pressure to find a solution as quickly as possible, even without an immediate need to refinance. In fact, the Irish have secured a bailout from the European Union and the International Monetary Fund.

All of this has reopened the debate around the role of the single currency, which in a way is an incomplete project simply because monetary policy is common but fiscal policy is not. Recently, economic growth in core Europe and in particular Germany has been relatively strong. Also, the European Central Bank has been far more reluctant to introduce easing measures than the Federal Reserve, so European yields are far more attractive than in the U.S. Together, these factors have helped boost the value of the euro. Meanwhile, the peripheral nations have been quite weak from an economic growth and fiscal standpoint. Without the euro, their currencies would likely have been devalued, which would have helped their competitiveness, growth picture and potentially their fiscal issues. As it stands, they continue to find it very hard to compete with China and other Asian countries. Overall, these structural issues are causing people to look at the euro with fresh eyes and question whether its current valuation is too high, especially against the U.S. dollar and emerging market currencies.

WHAT’S YOUR OPINION OF THE YEN RIGHT NOW?
The yen has been the best performing G10 currency this year. The Bank of Japan’s effective exchange rate, a measure of the value of the yen versus a basket of major currencies, has appreciated 12% year-to-date through October 31.

Japanese yields have been close to zero for many years as the country’s central bank sought to avoid deflation. Until last year, Japanese investors looking for yield had to go abroad. Recently, however, the yield advantage that U.S. Treasuries and German government bonds had over Japanese government bonds has gradually disappeared. For instance, if you compare yields on two-year Treasuries and equivalent Japanese government securities, spreads have fallen from around 4% at the end of 2006 to 19 basis points as of October 31, 2010 — a drop of more than 380 basis points. Hence, demand for those securities has been reduced significantly — and, as a result, Japanese demand for the dollar and euro — has also faded.

In our opinion, the yen had gradually been moving into overvalued territory. Japanese authorities have expressed concern about the yen’s valuation repeatedly. At the end of the third quarter, the Bank of Japan even intervened in currency market, selling more than 2 trillion yen (or about $25 billion) to prevent further appreciation. Although this is a large amount, it is actually much less than what they sold in 2003 – 04. We expect the Bank of Japan to intervene again but only in the event of disorderly appreciation of the yen. In fact, major countries have in principle agreed to avoid competitive devaluations of their currencies and, for this reason, the objective of the intervention is likely to be limited and only aimed at avoiding excessive yen strength.

At current levels, we presently favor an underweight of the yen on a tactical basis. If global yields pick up as a result of renewed growth, the depreciation of the yen could be sharp and significant. However, the downside risk is likely to be contained as the Japanese authorities will continue to put a cap on the yen appreciation.

WHAT OTHER CURRENCIES DO YOU CONSIDER VULNERABLE VERSUS THE U.S. DOLLAR?
In our view, the Australian and New Zealand currencies appear quite overvalued. The Australian economy has been growing very fast — much faster than the market had expected, and the Reserve Bank of Australia has been well ahead of other central banks in raising interest rates. As a result, investors have accumulated very large long positions in the Australian dollar to benefit from those higher yields. A similar situation exists in New Zealand.

We are watching the situation very carefully. Should China gradually tighten interest rates to limit inflation, countries like Australia and New Zealand — which have large commodity sectors — could potentially suffer from a resulting slowdown in the emerging markets. The risk may not be imminent but it is something to be aware of, especially given the levels at which these currencies are trading. For example, the Australian dollar has recently been at its highest level versus the U.S. dollar in almost 30 years.

ANY FINAL THOUGHTS?
Overall, we believe that currencies will likely remain in large ranges as the economic and financial stabilization process continues. The environment will not be without volatility, but it’s pretty clear that no major country is willing to tolerate a clear currency uptrend because of competitiveness issues. After all, the developed economies are all focused on improving their economic growth.

 

 

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