November 7th, 2016 | By Nick Sargen
Over the past three years there has been a divergence in monetary policies by the Federal Reserve, the BoJ and the ECB. Of the three, the Fed has been seeking to normalize interest rates, while the BOJ has been the most aggressive in easing monetary policy. The ECB has continued to ease policy over this period, albeit less aggressively than the BoJ.
After pursuing several rounds of quantitative easing in the aftermath of the 2008 financial crisis, the Fed surprised the market in mid-2013, when it announced it would scale back purchases of bonds in 2014 as a prelude to raising interest rates. However, it was not until last December that the Fed was sufficiently confident about the economy and markets to raise the federal funds rate by one quarter of a percentage. Since then, it has refrained from tightening policy this year after it signaled it was contemplating four such moves one year ago. Nonetheless, this has not deterred the Fed from trying to normalize interest rates. Indeed, it has been sending strong signals to the market that it is prepared to raise rates again next month, and we think there is a good chance it will do so.
Meanwhile, the BoJ has eased monetary policy aggressively since Governor Kuroda took office in March of 2013: The central bank’s holdings of Japanese Government bonds (JGBs) have increased from 11% to 37% of total JGBs outstanding, and the BoJ aims to increase its holdings by Y80 billion annually (about 16% of nominal GDP), which far exceeds annual JGB issuance. Kim Schoenholtz, Professor at NYU’s Stern School of Business, notes that by next year BoJ assets will reach 100% of Japanese GDP, compared to about 35% for the ECB and 25% for the Federal Reserve. (See his blog on “Bank of Japan at the Policy Frontier,” October 31, 2016.) The BoJ has also experimented with negative interest rates this past year, and last month it announced a new framework that includes two key policy shifts: (i) the introduction of a target level for the 10-year JGB yield of around zero percent; and (ii) a commitment to continue expanding its balance sheet until inflation exceeds 2 percent and “stays above the target in a stable manner.”
For its part, the ECB has been pursuing unorthodox monetary policies since the summer of 2012, when Mario Draghi pledged he would do “whatever it takes” to maintain the viability of the euro. The ECB’s policies since then have helped lessen sovereign and private-sector credit risk, improved financial liquidity, and boosted asset prices. However, loan growth remains sluggish, as the banking sector is confronted with sagging profits that have been exacerbated by the experiment with negative interest rates. Many observers believe continued low interest rates could have adverse consequences for the banking system. In these circumstances, market participants have begun to anticipate the ECB could scale back its QE program in 2017, because the eurozone economy no longer is in jeopardy and the ECB is running out of eligible paper for it to purchase.
Normally, a tightening of U.S. monetary policy would be associated with a stronger dollar, particularly when the BoJ and ECB are easing their monetary policies. This was the case from mid-2014 until the end of 2015, when the dollar appreciated by 20% against the euro and by 30% versus the Japanese yen. During this past year, however, the dollar has been relatively stable against the euro, and it has depreciated by about 17% against the yen. (See Figure 1 below.) As a result, many currency market participants including several prominent hedge fund managers are wondering what went wrong.
A possible explanation is that currency traders believe the Fed’s bark is worse than its bite. Thus, while the Fed has been sending signals for the past three years about its desire to normalize interest rates, it has in fact acted very timidly: Whenever U.S. data is soft or developments abroad such as worries about China, oil, or Brexit have triggered sell-offs in financial markets, the Fed has held off from raising rates. Moreover, even if it were to act next month, as appears likely, market participants do not expect it to move again anytime soon.
Another explanation is that market participants are skeptical about the effectiveness of policy easing in Japan and the eurozone. The primary goal of monetary policy during Governor Kuroda’s tenure has been to end two decades of deflation in Japan. However, inflation and inflation expectations have failed to rise since aggressive policy easing was introduced in April 2013. As Kim Schoenholtz notes: “perhaps most disheartening is the plunge in early 2016: over the month following the BoJ’s announcement of its negative interest rate policy on 29 January, the Japanese inflation swap rate declined from nearly 0.5 percent to zero.”
It is against this backdrop that the BoJ undertook a “comprehensive assessment” of economic conditions and the impact of monetary policy, and formulated its new framework to target the 10-year JGB bond yield and to target an inflation rate that exceeds 2 percent. The main challenge the BoJ faces, however, is that market participants are skeptical these measures will work, considering the central bank has not been able to end deflation after two decades. Consequently, the 10-year JGB yield has barely budged since the policy was enacted, while the yen has weakened only modestly. The end result is the yen is still 14 percent stronger versus the dollar than it was on average in 2015, while the Japanese stock market is down by 12 percent.
While monetary policies are often the key determinant of currencies, they are by no means the sole determinant. Other factors that may influence currencies include fiscal policies, exchange rate policies, trade and current account imbalances, and a broad array of factors that influence the confidence investors have in policymakers.
In this regard, the U.S. presidential election could have an important bearing on the direction of the U.S. dollar. Should Hillary Clinton win, we would not expect a major change in economic policies, especially if the Republican Party retains control over one or both houses of Congress. Therefore, the outlook for the dollar would likely continue to be influenced primarily by the policies of the Fed and other central banks.
Should Donald Trump be victorious, however, there is a chance the dollar could weaken against the key currencies and the Chinese yuan for several reasons: (1) Trump believes trade deficits are a sign of weakness and he has accused the Chinese government of manipulating its currency to gain a competitive advantage. (2) If he were formally to declare China to be a currency manipulator, the Chinese are likely to retaliate, and they could opt to refrain from purchasing assets in the U.S., which would weaken the dollar. (3) Overseas investors, in general, are leery of Trump’s nationalistic stance and his condemnation of globalism.
The main offset is that Trump’s commitment to large scale tax cuts for individuals and businesses, his endorsement of increased spending for the military and infrastructure, and aversion to changes in entitlements. This combination raises the specter of large increases in the federal budget deficit. If so, such fiscal expansion would likely be accompanied by more aggressive monetary tightening, which would boost real interest rates. However, whereas similar policies contributed to record dollar strength during the first term of the Reagan Administration, we do not foresee a repeat this time, mainly because President Reagan was also an ardent supporter of a strong dollar. In this regard, Trump’s exchange rate policy is likely to be very different.