Quantitative easing could boost some currencies

Business Times - 04 Apr 2009

NEW YORK - Major central banks which have recently ventured into 'quantitative easing', or direct expansion of the money supply, as a way to fire up slumping economies, may yet find the strategy strengthens their currencies unless inflation is allowed to get out of control.

With benchmark interest rates near zero, the Federal Reserve, Bank of England, Swiss National Bank, and Bank of Japan have recently flooded their markets with cash, printing money to buy domestic debt as they try to stimulate lending.

Given the right exit strategy, analysts said this widely-used monetary tool could attract investment flows as their economies return to growth, boosting their currencies.

'So long as investors believe excessive inflation is not being risked by central banks' quantitative easing, increased ...growth prospects can support the currency,' said Michael Metcalfe, head of macro-strategy at State Street in London.

Some investors fear the launch of these unconventional measures may pressure currencies such as the US dollar, sterling, Swiss franc, and yen, with some analysts declaring the Fed move as the death knell for the safe-haven dollar.

Investors are concerned quantitative easing could undermine a currency's value through a rise in money supply which could potentially lead to high inflation. The strategy also raises questions about a government's commitment to keep fiscal budgets under control.

But as central banks like the BoE and Fed have started buying domestic debt, the US dollar and sterling have survived.

The British pound has risen 10 per cent from its lows hit in January. Investors have rewarded the currency for the aggressive stimulus measures by the British government.

In the US dollar's case, the greenback has recovered from sharp losses incurred after the Fed's announcement last month that it would buy US Treasuries.

The US dollar tends to rise in response to bad news because investors view it as the safest store of value at a time when economies around the world are contracting.

John Taylor, chairman of the US$12.5-billion hedge fund FX Concepts in New York, said the perpetual shortage of dollars has made the US currency strong. Despite cash injections by the Fed, banks are still cutting back on lending, he added.

'Even if the Fed is supplying an extra US$10-US$14 billion a week to banks, this is not nearly enough to loosen the financial noose on Main Street or in the global loan market.'

Quant easing starting to bear fruitStill, State Street's Metcalfe said quantitative easing is starting to bear fruit and he cited the rise in cross-border flows into US and UK equities, while their respective bond markets have yet to price in a rise in inflation.

Meanwhile, the case of the SNB and BoJ is a little different and analysts said their quantitative policies should more than likely weaken their currencies. The Swiss central bank, for one, is using extra francs to buy overseas bonds precisely to weaken its currency as it tries to avert deflation.

The BoJ, on the other hand, is in the midst of a second quantitative easing period, which some believe may not be enough to pull Japan out of recession. Subsequent yen weakness would no doubt be welcome in export-oriented Japan.

Historically an expansion of the money supply has often been associated with currency strength, particularly in the United States. Ronald Leven, currency strategist, at Morgan Stanley said US broad money growth tends to be correlated with credit demand and economic growth.

'Quantitative easing may eventually prove to be currency-supportive once it succeeds to jump-start the growth of bank credit,' although it could take time before broad money growth boosts a currency.

Central bank debt purchases and the goal of hastening economic recovery could also bolster a currency through higher interest rate expectations, analysts said.

Both the Fed and BoE have identified a specific part of the yield curve in which government purchases could take place.

In the Fed's case, it buys Treasuries with tenors of two years and higher, while the BoE purchases gilts with maturities of between 5-25 years. Central bank purchases should lower long-term yields but they should also stimulate increased economic growth and raise the prospect of inflation.

In any case, analysts suggested it would take time before quantitative easing spills over to enough money supply growth to raise consumer prices.

'It's a very long chain of events before you actually get inflation,' said Robert Blake, currency strategist at State Street in Boston. What is important, he added, is a central bank's credibility in containing inflation and exiting the strategy if and when they need to.

But until then, Mr Blake said the US dollar will continue to draw safe-haven flows as the world's top reserve currency.