EUR/USD on its way to 1.40 - 1.45??
The Fed’s decision to open the liquidity taps until the unemployment rate has declined sufficiently, has potentially enormous consequences for global financial markets. Does this mean EUR/USD is on its way towards 1.40 – 1.45?
Fed loosens policy more aggressively
Yesterday, the Fed has announced several monetary stimulus measures to provide an additional boost to the US economy. Most importantly:
- The Fed will hold the short-term interest rate exceptionally low, at least until 2016
- The Fed will purchase a monthly amount of $40bn in mortgage bonds
- The Fed will continue ‘Operation Twist’: buying long-term US government bonds from the banks in return for ‘money that the Fed creates itself’
These measures amount to a less loose monetary policy than investors had hoped for. However, what clearly changes the picture is that the intended measures can be adjusted as necessary at a later date. This will depend on economic developments, especially that of the labor market. Should the unemployment rate not drop sufficiently, the Fed has indicated it is willing to open the liquidity spigots even further.
According to the Fed’s own estimations, subsequent rounds of ‘Quantitative Easing’ has generated around 2 million jobs. Most economists disagree; they estimate a much lower effect on employment. Therefore, they doubt whether the Fed’s recently announced measures will provide any respite to the economy at all, as:
- interest rates are already so low that they cannot be suppressed further
- interest rates near historic lows so far have failed to stimulate consumption, while they force households to save more to generate the desired final provisions
- money creation in this environment will push up commodity prices – especially the price of oil
- money creation may boost stock prices as well, and provide banks with more liquidity they can lend, but stock prices are highly unlikely to stimulate consumption and banks are already contending with much excess liquidity
In this environment, we believe it is indeed a long shot for the Fed to encourage credit activity, also in the housing market where the Fed hopes the extra push that purchasing mortgages entails will lift prices.
Most economists suggest that the net effect on the economy is small. However, (long-term) inflation risks are rising. They conclude that the Fed is then only taking these measures for precautionary reasons; without further action, the global economy would weaken shortly.
The financial markets are taking into account two main possible scenarios:
- The Fed will be proven right and the US unemployment rate will come down in the near term. Initially, the Fed’s program will weaken the US dollar, while lifting stocks and commodity prices. For yields on 10-year US government bonds, this will be neutral. Inflation expectations are rising (this puts long-term rates under upward pressure), but, meanwhile, demand for bonds from the Fed rises. In addition, demand for US bonds will also increase as a result of emerging markets having to intervene more to prevent their currencies from strengthening vis-à-vis the US dollar. Thereby, the US dollars purchased will be largely invested in US bonds. As soon as the unemployment rate starts to come down, the process described will reverse, because investors will then start to anticipate the Fed withdrawing as a buyer on the bond market. Therefore, the US dollar will strengthen, stocks and commodity prices will drop, and interest rates will rise
- The – skeptical group of – economists will be proven right and the unemployment rate will not decline substantially. The Fed will then be inclined to open the money taps further, placing the US dollar under downward and commodity prices under upward pressure. Initially, US long-term interest rates will probably remain constant. However, we then expect growing worries over escalating government finances and inflation risks due to the money creation to lead to gradually rising rates eventually.
In our opinion, the chances are largest that the second scenario will emerge. It is difficult to envisage how much further EUR/USD will rise as a result of continuing aggressive easing by the Fed. After all, this also has much to do with developments in the Eurozone. Given the structurally weak Eurozone economies, any rise of EUR/USD beyond 1.40 – 1.45 will be hard to imagine. Especially for the ailing peripheral economies, such a strong euro/weak US dollar will be the death blow.
Moreover, the tensions in the Eurozone are set to escalate yet again, in our view. Investors will thereby be inclined to sell their euro assets and (partly) flee to the US safe haven, notwithstanding the Fed’s loose monetary policy. This means the probability of EUR/USD breaking the 1.40 level shrinks further. Nevertheless, developments should continuously be monitored closely to see whether this will turn out correctly.