Does less QE from the Fed necessarily mean a stronger dollar?

August 16, 2013

Based on the latest U.S. Treasury flows data, it may be time to ditch the textbook theory that says less monetary stimulus means a stronger currency – at least for now.

The problem may just be that the theory doesn’t fully account for the situation when your largest creditors – and they are very large – are trying to beat you to the market.

The Federal Reserve first hinted in May it would start reducing its bond purchase programme because the U.S. economy is recovering and so is the job market.

Predictably, that news sent Treasury yields higher, with the dollar in tow. And analysts began pencilling in more gains for the greenback when the central bank actually begins scaling back.

But that move also spooked China and Japan – the largest foreign holders of U.S. debt.

Data on Thursday showed foreign investors sold in June the largest amount of U.S. Treasuries in one month since records began in the late 1970s.

China and Japan together dumped some $40 billion worth of longer-dated bonds, about the amount the Fed is currently buying each month.

Of course that is a paltry sum compared to their joint holdings of over $2 trillion in U.S. debt.

But if these Asian giants start selling with more vigour, the Fed will have a difficult choice between either pushing ahead, or treading more cautiously with their plans to taper their monthly bond purchases.

The latest Reuters poll predicts that the Fed will begin trimming back its purchases next month, but only by $15 billion, slightly less than the $20 billion previously expected.

And the latest Reuters foreign exchange poll showed the dollar will gain 7 percent, 3 percent and 10 percent against the euro, sterling and the yen respectively over the coming year.

But if Uncle Sam’s largest creditors are trying to reduce their holdings before the Fed can start, chances are the currency will not rise and may fall instead.

John Noonan at IFR Markets writes:

It has been assumed by the market and most analysts (me included) that the advent of Fed tapering would coincide with a period of U.S. dollar strength.

This was a reasonable assumption based on the theory that Fed quantitative easing is U.S. dollar-negative – so naturally the beginning of the end of Fed QE would result in the U.S. dollar strengthening.

The TIC (Treasury International Capital) data released yesterday throw some doubt on that basic assumption.

If they (China and Japan) get spooked by the Fed ceasing to buy up a large portion of the new U.S. debt and they start paring back their Treasury holdings – we could see the unusual dynamic of the U.S. dollar falling while the longer-date U.S. Treasury yields move ever-higher.

Analysts at Citi also write:

The recent weakness in capital flows stands in stark contrast to widespread market expectation that U.S. economic outperformance and heavier securities buying will form the basis of medium-term USD appreciation.

We remain USD bulls for the time being, but the TIC (report) raises further questions about the sustainability of the uptrend in the medium- to long-term.



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