Newsletters 2010 Newsletters Currency Wars Simmer
Friday, 15 October 2010 14:17
Last month’s newsletter cover story titled “Renewed Optimism” outlined our more constructive thesis on the stock market as we approach year-end, highlighting the August selloff as an opportunity to invest a portion of our cash reserves. Sure enough, the stock market enjoyed its best September in 70 years with the Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite jumping 7.72%, 8.76% and 12.04% respectively for the month. These significant market barometers are now up 3.45%, 2.34% and 4.38% respectively year-to-date. The composite of all equities under management at Osher Van de Voorde rose 8.35% for the month and are now up 5.27% for the year through September.
In addition to a “buy the dip” mentality that lured investors back to stocks after such an awful August, several key factors seem to be behind the market’s recent move. First, the November elections are supplying an almost gravitational pull for equities as significant turnover in Congress is expected and will restore much needed checks and balances in Washington. Second, evidence continues to mount that fears of an imminent “double dip” recession were way overblown. Finally, investors are growing increasingly convinced that the Federal Reserve is set to administer an even stronger dose of quantitative easing (QE2), with mounting speculation of an imminent announcement in November that the Fed will buy an additional $500 billion to $1 trillion of U.S. Treasuries.
Since Fed Chairman Bernanke’s late August speech at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming, virtually every asset class has witnessed sizeable gains. During that speech, Bernanke stated that the Federal Reserve is “committed to promoting growth in employment and reducing resource slack more generally” and that “the FOMC will do all that it can to ensure continuation of economic recovery”. Further, the Fed Chairman laid out specific tools that the Fed might utilize, emphasizing that “additional purchases of longer-term securities would be effective in further easing financial conditions”. Then, after the September meeting of the FOMC, the Fed took a collective step towards QE2 by stating that “measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent” and the Committee is “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”.
The President of the Federal Reserve Bank of Chicago, Charles Evans, further stoked expectations for QE2 by stating in early October that he favors “much more accommodation than we’ve put in place”. Evans went even further and stated that additional purchases of U.S. Treasuries “would not be enough” and floated the idea known as “price-level targeting” where the Fed would allow inflation to run higher than its informal 2% target for a period, pushing real interest rates lower or even negative in order to promote higher inflation.
With the Fed Funds rate already at zero, the Fed is left to ponder alternative means to reduce unemployment and stimulate the economy. Quantitative easing seemed to make a lot more sense when we were in the midst of panic and fears of deflation overwhelmed the market. Today, however, panic is clearly in the rearview mirror, the economy has stabilized (albeit at a less-than-desired “new normal” pace) and deflationary alarmists are slowly turning their attention to budding risks for inflation. So why would the Fed find it necessary to embark on another significant round of quantitative easing?
In theory, additional quantitative easing will help drive long-term interest rates down even lower and spur additional demand for new loans. It is assumed that increased lending activity will jump-start growth since consumers are able to spend money saved by refinancing and businesses can use borrowed funds for expansion. Yet the Fed’s own models, according to the Wall Street Journal, estimate that a purchase of $500 billion in Treasuries would stimulate annual GDP growth by only 0.2% and reduce unemployment by 0.2%. This hardly seems worth it. Even before QE2, we wrote in April that we worried about the potential “unintended consequences of excessively easy monetary policy”. Now that the Fed already seems to have one foot into an expansion of QE2, we again are left wondering of the unintended consequences of such extraordinary measures.
It has been well reported that banks are sitting on an approximate $1 trillion of reserves in excess of their legal requirements and non-financial corporations have another $1 trillion of cash on their balance sheets. And retail and institutional money market funds hold another $2.8 trillion of cash. These astounding numbers do not suggest any lack of liquidity. With trillions of dollars already sitting idle, it is difficult to see how increasing the money supply will somehow reduce unemployment.
The Fed’s motive may be to ignite the market’s “animal spirits”. With cash and short-term fixed investments such as CDs and Treasury Bills already yielding next-to-nothing, driving interest rates lower still will further boost the attractiveness of stocks and other assets such as real estate. Higher equity and real estate prices would boost consumer spending and GDP through what’s commonly known as the “wealth effect”.
It is also conceivable that just the promise (or threat) of QE2 is entirely designed to increase expectations for higher inflation. The market selloff in August was a direct result of fears for a double dip and the perceived threat of a prolonged bout of deflation. Less than two months have passed and the markets seem now more concerned with the prospect for rising inflation. Indeed, talk of QE2 and rising inflation expectations may have finally put a dagger in the worst-case deflation scenarios that had captured the imagination of many market pundits. And the absence of deflation as a real and present danger is reason enough to justify the big recent move higher in the stock market. In the same Jackson Hole speech that initially triggered market expectations for QE2, Bernanke explained the shortcomings of quantitative easing. He explained that “another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit”. Without any specifics of QE2 yet announced, the Fed may have been able to sway sentiment and expectations for higher inflation simply through the power of the pulpit. In any case, with such a strong move from the August lows, we would not be surprised if the market is ultimately disappointed with any actual announcement of QE2 specifics by the Fed. After all, for all its potential benefits, QE2 is an admission by the Fed that the economy is not strong enough to reach escape velocity without unprecedented monetary encroachment.
It seems to us that the economy’s inability to reach a higher level of growth and lower level of unemployment has nothing to do with monetary policy being too tight or any lack of available capital. Instead, uncertainty over government policy has led to a “capital strike” by investors and business owners. Until investors and business owners know what to expect with taxes, health care, energy and regulatory costs, they cannot know what return to expect on any new investment. Hence, it is very rational for so much cash to remain idle in the face of such uncertainty.
Unfortunately, the Fed’s anticipated QE2 campaign is set to occur amidst the backdrop of record deficit spending by Congress and the Obama Administration. One of the unintended consequences of QE2 then is that the Federal Reserve is effectively underwriting a profligate government, sending a potentially dangerous signal to our trading partners around the globe.
As one might expect, the mere suggestion of the QE2 printing press working on all cylinders has caused the dollar to weaken of late. While a cheaper dollar is beneficial for U.S. multinationals that derive much of their growth from overseas, it is conversely a headwind for foreign companies that compete with the U.S. The financial crisis and subsequent panic that plagued the markets in 2008 and into early 2009 resulted largely from excessive leverage in the system, especially by the consumer and especially in the United States. In the aftermath of the crisis, the U.S. consumer is now engaged in a multi-year “deleveraging” process and is no longer seen as the engine of U.S. GDP growth, indeed of global growth, as it was in years past. As the consumer pays off or refinances its collective debts, the U.S. economic recovery has been led by strong export growth, growth that will inevitably receive a boost from a weakening dollar.
Even before the crisis, global “rebalancing” has been a well telegraphed goal of the G20, a group of leading nations established in 1999 to increase cooperation between major advanced and emerging economies in order to stabilize the global financial markets. The thrust of “rebalancing” is for trade-surplus countries such as China and Germany to shift away from export-led growth to domestic consumption, while trade-deficit countries, especially the U.S., boost savings and reduce imports, with a more stable global economic order being the hoped-for end result.
Due to the unanticipated swiftness to which the U.S. consumer has lost his collective appetite to spend, the global economic crisis has thrown a giant monkey wrench into the seeming well-intentioned goals of “rebalancing”. With the United States housing bubble at the root of the global economic collapse and with the subsequent retrenchment of the U.S. consumer, emerging economies such as Brazil, Russia, India and China have gained prominence and become the new engines of global growth. Rapid growth in these emerging nations and subsequent demand for commodities and infrastructure-build has been a boon for exports nations and set the stage for increasing global competition as countries seek to export their way towards prosperity.
Yet another (perhaps) unintended consequence of QE2 then is the extent to which the weakening dollar has promulgated a simmering currency war. The United States and to a lesser extent the EU have long complained that China’s currency is dramatically undervalued, thereby subsidizing Chinese exports and serving as an unfair competitive advantage for Chinese companies. With the dollar sinking to a 15-year low against the Japanese yen, a record low against the Swiss franc and its lowest level since 1983 against the Australian dollar, U.S. exporters stand to gain ground on their competitors. Since China has pegged its currency (the yuan) to the U.S. dollar, China has not lost the same competitive leg to the United States as other countries have. Another way of looking at it, when the currency of a country rises against the dollar, it also rises against the currency of China, making their goods less competitive to both American and Chinese goods.
The result is the rising threat of protectionism via competitive devaluation and currency intervention. Countries such as Taiwan, Thailand, Brazil, Columbia, Peru, Japan and South Korea have already taken accelerated action, beyond normal intervention, to weaken their own currencies in order to remain export-competitive. On the speculation of QE2 alone, Japan announced a $60 billion central bank plan to buy bonds and other assets to spur growth and restrain the rising yen. Brazil’s Finance Minister Guido Mantega recently stated that “we’re in the midst of an international currency war” and announced measures to raise taxes on foreign inflows into Brazilian bonds as a means to curb the rise in the Brazilian real And the Reserve Bank of Australia opted not to raise interest rates recently, despite rising inflation and strong growth, as a means to reduce the appeal of the Australian dollar.
Ironically, despite the debt crisis in Portugal, Spain, Ireland and Greece, the euro has risen sharply against the dollar of late as trade-surplus countries with excess reserves look to diversify away from the weakening dollar. While it cannot be proclaimed with any certainty, we would hypothesize that EU austerity measures serve as a stark contrast to a spendthrift U.S. government and add to the appeal of the euro vis a vis the dollar. Indeed, as the Fed prepares for QE2, the EU is reviewing fresh proposals aimed to impose fines and other penalties on wayward member nations that do not abide by EU standards for acceptable debt levels.
Extraordinary volatility in currency markets is a destabilizing force for the global economy in the same way that uncertainty over U.S. government policy is a destabilizing force in the U.S. Sharp currency moves lead to wide swings in prices, especially for commodities, and make it very difficult for businesses to plan effectively, with investments necessarily reconciled as much to short-term exchange rates as to long-term productivity.
The upcoming November meeting of the G20 in South Korea will serve as an important medium for countries to air their differences on looming currency issues. We remain optimistic that cooler heads will prevail and that the same spirit of cooperation that surfaced after the recent global economic crisis will again emerge to thwart full scale trade and currency wars. As a seemingly small gesture to Larry Summer’s early September visit to Beijing, China has allowed the yuan to rise 2% against the dollar. Further incremental gains in the yuan along these lines are anticipated over the coming months and would likely go a long way to curb some of the budding protectionist threats.
Reckless deficit spending and massive quantitative easing potentially place the dollar’s standing as reserve currency for the world at risk. Of course, this has not been lost on the markets as bond yields have tumbled while gold prices soar. The two-year Treasury recently touched a record low yield of 0.355% and the five-year Treasury hit an all-time low yield of 1.119%. Ten-year Treasury bonds and thirty-year Treasury bonds offer yields at 2.396% and 3.712% respectively.
Equities, bonds and commodities have all soared on the prospects for QE2. All of these asset classes cannot continue riding this “one-way ticket” indefinitely and we expect decoupling to occur perhaps in the not-too-distant future. If the Fed has its way and is successful in creating higher inflation, we can’t help but think that bonds are the asset class that stand to lose the most. This would be especially true if trade-surplus nations previously willing to finance our deficits and emboldened by a sense of protectionism become disenchanted by the dollar’s decline.
In other signs of an increasingly one-sided trade, eighty percent of institutional investors polled in a recent CNBC survey expect the Fed to announce more QE at the November 3rd FOMC meeting; the Daily Sentiment Index of futures traders on the dollar registered only 3% of traders bullish on the dollar and the same Daily Sentiment Index showed that 95% of traders are bullish on gold. It seems that this sort of lopsidedness is bound to end in disappointment as the bark of QE2 may prove to be worse than the actual bite.
We expect the Federal Reserve to announce a form of QE2 that will give the Fed flexibility to act gradually based on future economic data, rather than a one-time “shock and awe” delivery. And, we remain convinced that the November elections will restore much-needed balance in Washington and limit the propensity for the Obama Administration to try to spend its way out of the economic crisis. A more muted delivery of QE2 than the market currently anticipates combined with greater checks and balances in Washington should stabilize the dollar. In the long run, a strong U.S. dollar helps keep inflation low, reduces the potential for a spike in energy and other commodity prices and allows the U.S. to maintain its anointed position as the reserve currency of the world. In the short run, the Fed seems poised to reduce the dollar’s appeal in its bid to stamp out deflation.
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