CITI: The FX Markets Are Signalling An Early End To Fed Stimulus

Steven Englander

Photo: Bloomberg

Nov. 16 (Bloomberg) — The foreign-exchange market is signaling to Citigroup Inc. that it isn’t yet convinced the Federal Reserve will fulfil its pledge to keep pumping record amounts of cash into the U.S. economy through 2015.The U.S. Dollar Index has gained 2.2 per cent since the central bank said Sept. 13 it would keep interest rates at record lows through mid-2015 and print $40 billion a month to buy bonds, a policy that debases the currency. Higher-yielding currencies from the Czech koruna to Poland’s zloty that benefited from such actions in the past are weakening.

While the Fed said it will keep the stimulus going even after data show the economy is improving, the foreign exchange market indicates that gains in U.S. employment, housing and consumer confidence may prompt changes in policy sooner. The dollar will rally next year versus the euro and yen, based on the median estimate of more than 50 strategists from Barclays Plc to Nomura Holdings Inc. surveyed by Bloomberg.

“Does the market really believe that the 2015 Fed is going to be constrained by the 2012 Fed?” Steven Englander, Citigroup’s New York-based global head of G-10 strategy, said in a telephone interview from New York. “The answer is ‘no.'”

Dollar Strength
Citigroup sees the dollar strengthening to $1.22 per euro by the end of next year, from $1.2781 yesterday, and holding steady at about 79 yen, from 81.17. The median estimate of strategists surveyed by Bloomberg is for gains to $1.25 per euro and 83 yen.

The third-largest U.S. bank by assets anticipates appreciation in the dollar even as Englander said the Fed is likely to add to its current quantitative-easing measures, or QE3, next year by purchasing Treasuries in addition to mortgage bonds. That would reassure investors and spark a rally in the Australian and Canadian dollars, he said.

The strengthening U.S. economy is overcoming concern about the Fed swelling the supply of dollars after already injecting $2.3 trillion into the economy by purchasing bonds. In its World Economic Outlook published Oct. 9, the International Monetary Fund said gross domestic product in the U.S. will expand 2.1 per cent next year, compared with an average of 1.5 per cent for all advanced economies.

“Mid-year, the market might start pricing in an earlier exit by the Fed because the private sector is actually rebounding,” Christine Hurtsellers, chief investment officer for fixed-income in Atlanta at ING Investment Management, which oversees $170 billion, said Nov. 13 at a conference in New York.

Economic Indicators
American employers added a net 171,000 workers to payrolls in October, after 148,000 in September that was more than first estimated, labour Department figures showed Nov. 2. The Thomson Reuters/University of Michigan preliminary consumer sentiment index rose to 84.9 in November, the fourth straight increase and the highest since July 2007.

Residential real-estate prices as measured by the latest S&P/Case-Shiller index of property values in 20 cities increased 2 per cent in the 12 months ended August, the most in two years.

Demand is stronger for options contracts that protect against a rise in the dollar against the Group of 10 currencies, than for those that insure against a decline. There’s an average 1-percentage-point premium in favour of dollar calls, or the rights to buy the greenback, to puts, which allow sales, according to three-month 25-delta option risk reversal rates.

QE Reversal
Three weeks after the Fed announced on March 18, 2009 that it would purchase $300 billion of Treasuries as part of QE1, demand was greater for dollar puts versus the yen, Swiss franc, euro and Danish krone, as traders protected themselves from a weaker U.S. currency. That was also the case after the central bank began to buy $600 billion of Treasuries in November 2010.

The Dollar Index fell 6.3 per cent during QE1 between November 2008 and March 2010, and declined 8.5 per cent during QE2, which began in November 2009 and ended in June 2011.

So far, this time is different. The dollar has gained against 13 of its 16 main counterparts since Fed officials led by Chairman Ben S. Bernanke, frustrated by the slow recovery, said they plan to purchase $40 billion of mortgage bonds a month until job growth shows “sustained improvement.”

“A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity-extension program,” according to the minutes of the Federal Open Market Committee’s Oct. 23-24 meeting released Nov. 14 in Washington.

Market Reaction
Unprecedented stimulus from global central banks to boost economic growth may be losing its effectiveness, based on financial markets. The South African rand has fallen 7.7 per cent and Canada’s dollar slipped 3.3 per cent. The so-called Aussie has declined 2.1 per cent. The koruna has weakened 6 per cent and zloty fell 3.5 per cent.

Other assets that in the past gained as the Fed stepped up stimulus measures are also falling. The MSCI World Index of stocks has declined 5.7 per cent since the Fed’s Sept. 13 announcement and gold has dropped 2.9 per cent.

Currency prices may be reflecting demand for a haven from renewed turmoil in Europe’s debt markets and concern U.S. lawmakers won’t agree to postpone more than $600 billion in mandated spending cuts and tax increases starting Jan. 1 that would slow global growth.

“Long-term investors haven’t divested aggressively out of the dollar, even on the basis of QE3 and all these promises made by the Fed,” Sebastien Galy, a senior foreign-exchange strategist at Societe Generale SA in New York, said Nov. 13 in a telephone interview. “One of the reasons is the lack of alternatives.”

Seeking Safety
Demand for safety is also reflected in Treasury 10-year yields, which fell below 1.6 per cent this week from 1.87 per cent on Sept. 14.

HSBC Holdings Plc’s Global Hazard Indicator, which combines implied volatility readings in options for the dollar, euro and yen, shows investors may be expecting wider price swings in currencies during the next year than in the coming three months. The firm’s three-month hazard index was most recently at 10.3 per cent, below the one-year level of 12.1 per cent

To increase its credibility, the Fed needs “to put their money where their mouth is and to do the unsterilized balance- sheet expansion by buying Treasuries again,” Englander said.

All of the Fed’s 21 primary dealers forecast the central bank will add Treasury purchases to its QE3 program, according to a Bloomberg survey last month. The Fed’s next policy meeting is Dec. 11-12.

‘Dust Clears’
“When the dust clears, in general, investors tend to want to be long emerging markets,” Win Thin, global head of emerging-market strategy at Brown Brothers Harriman & Co., said Nov. 11 in an interview with Tom Keene and Joe Brusuelas on Bloomberg Radio’s “Bloomberg Surveillance.” “Given the backdrop, it’s a bit dicey right now.”

ING’s Hurtsellers said she favours emerging-market bonds of speculative-grade sovereign governments and debt of companies in developing countries. Speculative-grade debt is rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s.

Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation suggest the Fed should end its stimulus efforts. John Taylor, an economist at Stanford University, published the formula in 1993.

It signals the Fed’s benchmark should be 0.65 per cent, or 40 basis points above the upper range of the current target interest rate for overnight loans between banks, assuming an inflation of 1.7 per cent, unemployment of 7.9 per cent and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 per cent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation.

About a year ago, the Taylor Rule model indicated policy rates should be minus 0.47 per cent.

The Fed has a target for price increases of 2 per cent. The consumer-price index increased by that much in October from a year earlier, the labour Department said yesterday.

If “unemployment rate gets below 7 per cent, you could have a Taylor Rule that suggests rates should go up and the question becomes do they overturn the Taylor Rule?” Englander said. “When perceived commitments are at stake, it’s a nightmare.”

–Editor: Paul Cox, Robert Burgess

To contact the reporter on this story: John Detrixhe in New York at [email protected]

To contact the editor responsible for this story: Dave Liedtka at [email protected]

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