Analysts react: Dollar dead, Fed credibility shot | FT Alphaville

Analysts react: Dollar dead, Fed credibility shot

Well, those are the most dramatic of the analyst community’s reactions to the Fed’s Wednesday announcement that it plans to start buying US Treasuries.

First, we hear from Deutsche Bank with a slightly more staid summary of the move.

The FOMC announced that it would expand its balance sheet by an additional $1.15 tn through purchases of Treasuries, agencies, and mortgages. The purchases make sense given the supply to the fixed income markets that will be coming in the next few months due to mortgage refinancing and Treasury issuance to fund the budget deficit. The Fed also said an “exceptionally low” fed funds rate is likely “for an extended period”, and anticipates a widening of TALF to embrace “other financial assets”.  …

The 50 bp rally in the 10Y after the announcement could very well continue to approach the lows of 2.05% of last December, which was also driven by expectations of quantitative easing. However, our central scenario is for 2.25% 10Y yield as our target. The Fed could be biased toward buying 2Y Treasuries because they are more liquid and there is more outstanding. However, the mispricing of on-the-run versus off-the-run is highest in the 10Y sector, which leads us to think the 7-10Y sector is most likely to be emphasized, in our view. Thus there will likely be a flattening of the curve, to 150 bp in 2/10Y. We also favor buying cheap off-the-runs, as these will likely be targeted for purchase. …

Finally, we expect the Fed’s $1.15 tn asset purchases to cause the monetary base to expand substantially. Currently the monetary base is $1.54 tn (with QE representing 75% increase) and M1 is $1.56 tn. However, the FOMC did not explicitly mention the impact on reserves, the monetary base, or sterilization. We think it more likely that most of the asset purchases would flow through to growth in the monetary base, and thus tighten basis spreads in the short end of the curve. …

The effect on the Fed’s balance sheet is best summed up by a chart from RBC Capital Markets.

RBC - Fed balance sheet forecast

The impact on US money supply is a point also picked up by Standard Chartered, in a rather ominously titled piece of research called “The day the dollar died”.

The Federal Reserve is in „full-court press? – an aggressive basketball tactic referring to the application of total pressure on all parts of the court. This is a signal that cautious half measures have been ineffective and that the Fed is ready to do what it needs to reduce ALL interest rates – not just short-term yields, but longer-term yields too in order to kick-start credit markets and lending. This is an extraordinary shift in intent that will give risk appetite a shot in the arm and send the US dollar (USD) reeling at the same time. …

There has been discussion all week of expanded Fed purchases, but few believed they would actually deliver. The Fed, perhaps buoyed by the reception of the Bank of England?s (BoE) announced purchase of gilts last week, has through these measures changed the playing field. This is another sign that policymakers, having called for greater policy coordination at the G20 summit last weekend, are beginning to walk the walk as well as talk the talk. In our view, the Fed?s balance looks set to expand even further. As of 11 March data, it has eased back to just below USD 2trn. These new measures should take the number north of USD 3trn, or roughly 25% of GDP. Adding contingency exposures from programmes such as the TALF may take it above USD 4trn. While investors react positively to the Fed?s statement of intent, the omission in the statement of their expectations of economic recovery “later this year” may sow some seeds of doubt for cynics. That said, the immediate reaction by markets is 1/ to sell the USD across the board 2/ to buy “riskier” assets such as equities and emerging markets (EM). …

From Q3-08 the USD has strengthened due to the global recession, deleveraging, investor repatriation and focus on bad news outside of the US. We expect that global economic expectations will bottom out in the Q2 which is bearish for the USD. This will resemble the episode in 2001-2002 where the USD strengthened during the US recession but fell off a cliff when US (and global) economic expectations bottom out in 2002. In addition, Fed quantitative easing policy is bearish for the USD given that it raises concern the Fed is monetizing its fiscal deficit and the Fed policy is unlikely to be replicated by e.g. the Reserve Bank of Australia (RBA), Reserve Bank of New Zealand (RBNZ) and the European Central Bank (ECB). As such, USD weakness should materialize sooner rather than later. In line with this we have moved forward the strength of the euro (EUR), Australian dollar (AUD) and the New Zealand dollar (NZD). We now believe that the peak in EUR-USD, AUD-USD and NZD-USD will be reached in Q4-09 instead of Q1-10.

Meanwhile Wachovia questions just how long a dollar-depreciation will last.

Although the greenback will probably depreciate further in the near term, it is not entirely clear that the dollar longer-term trend is down. Much will depend on how other central banks respond. If the European Central Bank engages in its own version of “quantitative easing”, then the euro could give up the gains it has racked up over the past few days. In addition, if the Fed’s actions have the effect of hastening the day that the U.S. economy begins to recover, then the dollar should ultimately strengthen. While we acknowledge that the dollar should depreciate further in the near term, we are not inclined at this point to make any major changes to our longer-run dollar forecast.

In the view of CBA’s chief currency strategist Richard Grace, the dollar’s large sell-off  was an “over-reaction” which will correct – mostly over the next week:

It is likely that the USD (and the US treasury curve) will retrace some 3/4 of last night’s move over the next week. This would mean over the next week, we are likely to see EUR decline to 1.3200, GBP to 1.4050 and the AUD to 0.6650. We are also likely to see AUD/NZD rise to 1.2480.

Meanwhile, Monument Securities’ hard-hitting Marc Ostwald sees the Fed’s move as mostly wishful thinking.

a) This looks to be an attempt to achieve maximum impact by co-ordinating the Fed move with the Treasury’s (Geithner’s) toxic asset plan details.

b) For that they have sacrificed the stated intention at the last meeting to wait and see the impact of the TALF before opting for what is the last card they have to play.

c) As for Bernanke’s cherished principle of transparency, that has now clearly been thrown overboard, and by opting to enact this just days after
Bernanke expressed the view that the US economy would recover in 2010, Mr Bernanke’s credibility is shot to pieces.

d) Will it work? Well it lower Treasury yields significantly, it will also offer market makers to stuff the Fed with Treasury paper at inflated prices, as the BoE’s QE buybacks has done for the BoE. Given that swap spreads ballooned out immediately, and that TIPS breakvens spiked higher, the intention “to help improve conditions in private credit markets” looks to be very wishful thinking in the first instance.

Sadly Anglo Saxon policymakers are digging an ever deep hole, with no signs that the measures do anything more than stave off an even worse outcome, but lacking the leadership qualities and ideas that would offer hope that they are capable of leading us out of this crisis. Should Mr Geithner’s tox asset plan continue to rely on market pricing mechanism (these are not functioning) and private sector capital funding for it, then the auspices for a resolution of the current crisis are very, very poor.

A final P.S., Fed will be buying TIPS in contrast to the BoE which will not be buying Index-Linked Gilts, which is welcome in so far as it might be hoped that this will help to sort a very dysfunctional TIPS curve, but the risk is that it creates even more dislocation.

Finally, IFR emphasises that despite the dramatic market reaction yesterday, this shouldn’t have been an entirely unexpected announcement.

From a March 16th note:

Over the last two weeks what has been most striking is that the market has tended to react sharply to events that ex-ante seemed to have been fully expected. Firstly, there was the BoE’s move to adopt QE on March 5 which was communicated by both the UK Treasury and BoE. Much of the analysis out on the street suggested that gilts would form the cornerstone of QE given the small size of the corporate bond market. Once the announcement was made gilts rallied sharply and continued to do so the following week. Second, there was the SNB announcement last week (Mar 12) that was expected to focus on FX intervention. Again the analysis on the street suggested that it was priced especially after SNB’s Hildebrand’s speech on Jan 21. The announcement last week from the SNB saw a significant rally on EUR/CHF toward 1.5400 after trading around 1.4800.

The FOMC meeting this week is seeing a lot of focus on whether the Fed will start to move from credit easing to quantitative easing…that is the outright purchase of Treasuries. The way in which the market reacted to the BoE and SNB suggests that being long Treasuries over the FOMC meeting is an attractive bet over the FOMC meeting from a risk/reward perspective.


Related links:
To twist a Treasury – FT Alphaville
Rescuing banks, then Treasuries – FT Alphaville
US Treasuries, not treasured by Fed, or Gross – FT Alphaville