As Sara Zervos previously discussed on January 22, the Bank of Japan (BOJ) announced it would raise its inflation target to 2% from 1%. In doing so, it pledged to implement monetary easing policies necessary to reach that target. Closer to home, the Federal Reserve (Fed) made headlines in September when it announced that it would undergo an open-ended program to purchase mortgage-backed securities indefinitely.  Similarly in the UK, Chancellor Osborne and the governor of the Bank of England (BOE), Mervyn King, have openly signaled a willingness to reconsider the inflation targeting regime, tolerating higher inflation in order to revive the economy. Moreover, incoming governor Mark Carney has also signaled an open mind to additional unconventional policy measures.

Unlike the BOJ, the BoE and the Fed, the ECB may see its balance sheet contract over the next 12 months. January 30th and February 27th mark the earliest permissible repayment dates for LTRO and LTRO-2. Already, European banks have chosen to repay € 137 billion of the € 489 billion they borrowed from the ECB in the LTRO program, and there is now potential for more banks to announce such intentions on a weekly basis. 

But what does all of this balance sheet expansion and contraction mean for a country’s currency? The below charts signal an imperfect, yet directional relationship between exchange rates and the relative sizes of the respective countries’ central bank balance sheets. Historically, expansions in the balance sheets of a nation’s central bank have typically coincided with weakening of that nation’s currency. 

Expanding Balance Sheets Typically Signal Weakening Currencies

Source: Bloomberg, Haver Analytics, as of 1/31/13. Data after 1/31/13 is a projection which may not be achieved. Past performance does not guarantee future results. The EUR/JPY currency cross, which is the blue line and corresponds to the left-axis, is the exchange rate between the two currencies. The red line, which corresponds to the right-axis, is the difference between the size of the Bank of Japan’s balance sheet and the European Central Bank’s Balance Sheet, which gives an indication of the relative size of the balance sheets to each other.

Source: Bloomberg, Haver Analytics, as of 1/31/13. Data after 1/31/13 is a projection which may not be achieved. Past performance does not guarantee future results. The EUR/USD currency cross, which is the blue line and corresponds to the left-axis, is the exchange rate between the two currencies. The red line, which corresponds to the right-axis, is the difference between the size of the Federal Reserve’s balance sheet and the European Central Bank’s Balance Sheet, which gives an indication of the relative size of the balance sheets to each other.

The chart below depicts the changes in the balance sheets of the aforementioned central banks over the past three and six months, as well as the projected changes over the next 12 months. The balance sheets of the BOJ and the Fed have the potential to expand quite a bit, while the ECB could do just the opposite, which I believe will be a positive development for the euro. 

Source: Bloomberg, as of 12/31/12. *Next 12-month data is a projection which may not be achieved. Past performance does not guarantee future results.

To a large extent, the price movement of the euro year-to-date is already incorporating these developments, but we think there is more potential for euro outperformance relative to the rest of the G4, which is why it is currently one of the top positions in Oppenheimer Currency Opportunities Fund. But beware; “currency wars” are still the name of the game.  I will be watching for the point when European officials begin to “complain” about a strong currency as a sign that a reversal could be forthcoming. Keep posted.

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