Yesterday, the Federal Open Market Committee (FOMC) undertook extremely aggressive policy decisions. Not only has it committed to expanding the Fed’s balance sheet until the labor market strengthens “substantially”; it also indicated that a “highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens…” Wow! The likely result? I believe this stance will lead to a weakening of the U.S. dollar and start a new wave of competitive devaluation of global currencies–in other words, “currency wars.”
In my opinion, the developments from yesterday’s meeting are indicative of a new phase in the FOMC’s approach to monetary policy, pointing to an additional dovish tilt in the Fed’s reaction function. What leads me to this conclusion is that this aggressive policy action is being taken even while the FOMC (slightly) upgrades its outlook for the U.S. economy. For example, yesterday’s statement says that “economic activity has continued to expand at a moderate pace,” while in August it “decelerated somewhat.” This change could also be seen in the discussion of household spending, which it characterized as having “continued to advance” instead of its August assessment that it was rising “at a somewhat slower pace.” In other words, even though the economy seems to be recovering, the Fed delivered additional and open-ended easing anyway.
Another aspect of yesterday’s announcement that caught my attention is that it seems that the Fed is going back to the core of its mandate. Rather than focusing on marginal data improvements and/or surprises vs. consensus expectations, which is what investors typically do, Bernanke’s emphasis on labor market conditions in his most recent communications reminds us that unless the economy starts posting 200,000 to 300,000 new jobs on a monthly basis for a prolonged period of time, the Fed is failing its mandate. We are VERY far from that becoming a reality.
Effects on Global Currencies
This is bad news for the U.S. dollar. Markets have largely punished the U.S. dollar since the Jackson Hole speech on August 31. More specifically, from Jackson Hole until yesterday’s meeting, the U.S. dollar has lost about 1.8% against a basket of major foreign currencies, and an additional 0.7% in the post-meeting afternoon session.
I think there is more to come. As the Fed said, recent data are showing a U.S. economy that is actually improving, unlike Asia and the Eurozone. For this reason, the Mexican peso and the Canadian dollar are likely to outperform since they’re the most direct foreign beneficiaries of additional Fed easing and U.S. economic growth.
I also believe this new round of aggressive Fed easing will reinstate currency wars around the globe. We think Japan is the most likely to intervene to weaken their currency in the near term.
What about the euro? If I’m right that a new wave of currency wars is in the making, currency investors should seek the path of least resistance. What we learned after the last bout of currency wars, after the second round of quantitative easing, is that European currencies offered the most free-floating path of least resistance against U.S. dollar weakness. Especially given the four-year accumulation of underweight positions in the euro and European equities, accumulation of long positions have plenty of room to go. I expect that anything with a high euro beta, such as the Norwegian kroner, Polish zloty, Czech koruna, and Russian ruble, to outperform cyclical currencies with policy resistance, such as the Chilean peso, Colombian peso, Brazilian real, Turkish lira, and South Korean won.
What can lead to outright long positions in the euro? I am monitoring data surprises as measured by the Citi Europe Economic Surprise Index. They have not turned positive yet, but they’re moving in the right direction.