“Are foreign central banks rejecting Operation Twist?”
That’s the provocative question asked in a note by RBS strategists this morning — and while the answer is “no”, the rationale for it is both intriguing and touches on some interesting developments happening around the globe.
The question was prompted by Thursday’s weekly Fed balance sheet release, which showed a collective $34bn decline in the foreign official holdings of US Treasuries and US agencies. RBS reason that this has little to do with Twist and is merely the continuation of recent efforts by some foreign central banks to prop up their currencies:
The last two weeks have seen a shift. In certain currency crosses, two years of currency strength have been erased in two weeks, as the flight to quality/risk asset sell-off entered its latest phase and re-accelerated. Investors became increasingly concerned (rightly or wrongly) that the next leg of this crisis could be capital flight back home and thus a deleveraging of the EM investment thesis. EM currencies were sold, and thus the dollar bought (some of this has snapped back this week). …
Normally currency weakening may not cause a reaction from authorities, but many nations are also facing well-known inflation problems. So letting the currency weaken will only exacerbate that problem. Thus while I most certainly have no direct evidence that authorities turned around and bought their own currencies and sold dollars, discussions with the experts in such markets show this is not an unreasonable reaction.
In other words, the recent selling in Treasuries is more about dollar policy than it is about a lack of faith in US debt. (You probably needed only to look at yields all across the Treasury curve to know that.) This is speculative but entirely plausible.
But we find the rationale more interesting for what it says about what’s happening in the emerging world. Which is that some countries, notably Brazil, in two weeks have gone from worrying about losing the “currency wars” to worrying about winning and winning big, as The Economist notes today.
It reinforces how in just the last couple of weeks, you’ve seen a number of foreign central banks signaling that they’ll do what’s needed to boost their currencies. Why? Because the investor retreat from these currencies hasn’t really been driven by differences in monetary policy — not directly — but by investors dumping risky assets of all kinds without regard to their quality.
There are profound differences from country to country and we’re oversimplifying here, but these central banks have a delicate balance to achieve. They have resisted allowing their currencies to appreciate in recent years to maintain their competitive export positions. But the events of the past few weeks, mainly the capital flights out of these countries and into perceived safe(r) havens — like Treasuries, perversely — have been so sudden and violent that they have forced these countries to confront different problems faster than expected.
One problem that is straightforward and persistent is ongoing inflationary pressure, made worse by these precipitously falling currencies as retailers that depend on imports are compelled to pass along price increases to consumers. Another is that foreign investors — you know, the ones fleeing — want some reassurance that their capital won’t continue depreciating in value against their home currencies. Still another is that because the cross-border currency of choice is clearly still the dollar, foreign acquisitions and investment for those domestic companies pursuing them will become costlier.
(We’ve probably left some out.)
So what do these countries do? They sell Treasuries and agencies to get dollars, and then sell the dollars. Treasuries are what these countries bought when they were building up dollar reserves to hold down their currencies, so Treasuries are what they’ll sell to prop them back up.
But it doesn’t really have anything to do with Twist.
Related link:
Weaker real dims Brazil retailers’ expectations – FT Tilt