CitiFX® & LM Strategy August 26, 2010

FX Alert – QE2 as USD end-game

Steven Englander „ Recent extremely weak economic data have increased the odds of a
+1 212 723 3211 second round of QE.
steven.englander@citi.com
„ With Treasury yields and MBS spreads already low, a second round of
QE could be more aggressive and less orthodox than the first.
„ Further expansion of the Fed’s balance sheet and more direct efforts at
reflating the US economy will likely put downward pressure on the USD.

A second round of QE will likely put sharp downward pressure on the USD, to some degree versus the euro
and other G10 currencies, with potential for a broader USD sell-off. Foreign investors are likely to view the
renewed direct intervention as indicating that the Fed’s balance sheet expansion and implicit monetization of
fiscal expenditures are first line approaches to dealing with disappointing recovery prospects, rather than the
exceptional measures they were meant to be initially. This could have severe implications for foreign
perceptions of the quality of the US assets that they are accumulating in private and official portfolios, and
may lead them to draw the conclusion that USD weakness is less a by-product than a desired outcome of
these measures.
It is hard to argue that the EUR and JPY do not share some of the same weaknesses. However, the euro
zone is essentially self-financing, with private savings offsetting almost all public deficits, and fiscal deficits
remaining considerable smaller than in the US. Moreover, the euro zone’s fiscal austerity provides a
credible, if painful, signal of an underlying desire to reduce fiscal imbalances that so far is lacking in the US.
Even if the ECB maintains its ‘pragmatism’ on the collateral front, the reluctance to buy significant quantities
of government debt signals a desire to return to orthodoxy.
From a currency perspective the euro zone combination of external balance, fiscal austerity, ECB
pragmatism and reluctant sovereign buying is likely to be more attractive than the US mix of QE2, limited
deficit reduction and the need to finance a growing external imbalance while offering increasingly low rates.
Buying a little government debt while austerity is put in place is ultimately more credible than buying a lot
when austerity is not put in place.
We are more sympathetic to the view that the USD/JPY is close to its trough. The stronger yen is
increasingly negative for growth and wealth (through the reaction of equity markets to yen strength).
Japanese real interest rates are much higher than elsewhere in G3 because of deflation. This is not really a
currency plus because it is impossible for investors to arb the Japanese and USD CPI against nominal
interest rate differentials. It creates a headwind to growth that becomes more severe as deflation intensifies
and the yen appreciates.
To be sure the major euro risk remains that the austerity and slowing global growth will slow euro zone
growth to such a degree that a sovereign default occurs and has severe knock-on effects on other fiscally
weak countries. That clearly remains the major euro zone risk. However, investors have tolerated prior ECB
intervention well, and the ECB’s reluctant intervention to avoid the worst in sovereign debt markets has been
euro positive.
Concern that monetary policy is ineffective
Recent downward surprises in housing and investment data suggest a deepening risk that the US is entering
into a significant slump. Given the run of very weak data investors are now focused on the policy response,
with comments by Fed and international officials at Jackson Hole the ‘payrolls’ event of this week. Central
bankers are loath to admit that they may be pushing on a string, although the combination of balance sheet
constraints at commercial banks, idle balances throughout the financial system and low loan demand by
borrowers make this a possibility. Moreover unlike the first run at QE, neither the level of rates nor spreads
point to an obvious problem that a new round of QE can solve (unless they decide to buy Greek and Irish
debt). Our US Economists have stressed that “… monetary policy will need to err on the side of ease…. The
[Fed] reinvestment plan likely will be enhanced by more active balance sheet expansion or perhaps new
efforts to unblock credit.”
Consider the options raised by Alan Blinder in today’s WSJ (he characterises the Fed policy hand as weak):
1) Treasury and MBS spreads are already low, so the mileage out of further Fed buying may be limited
unless they go much deeper into private sector assets; 2) Committing to an even longer period of low rates

Market Commentary
CitiFX® & LM Strategy August 26, 2010

(as also suggested by our FI Strategy team), but subject to the risk that the commitment language is not
sufficiently effective; 3) Paying negative rates on reserves as a way of getting idle balances into the loan
market; 4) Getting bank examiners to ease up on healthy banks willing to make loans. Our US economists
have argue similarly that financial conditions remain tight and targeted policies may be needed to ease credit
conditions in segments that have not benefited so far.
To be sure there is a second view that argues that the liquidity injections are doing no good and will
ultimately do harm. For example, the University of Chicago’s Raghuram Rajan argues that the current level
of low rates are a subsidy to borrowers and risk takers, and like all subsidies will induce excess consumption
of the subsidized item, in this case risky investments. (This week’s WSJ article on Fed dissension implies
that he may have some sympathy among regional Fed Presidents and even some Governors.) Over the
longer term the low rates will add to moral hazard by conditioning risk takers to expect bailouts.
Despite the sympathy of some FOMC members, it is hard to see how far these arguments will influence
policy, unless accompanied by a positive argument for an alternative set of policies to reduce unemployment
and excess capacity. (Cutting real wages is hardly a policy runner given that there is no evidence that they
are too high. If anything higher wages would make servicing mortgage debt easier rather than harder).
Debt still out of line with ability to service it
There does seem to be a consensus is that a broad gap remains between how debt is priced on the books of
borrowers and lenders and the ability of the associated assets to service that debt. The fundamental policy
question becomes how to get this relative price between debt and the ability of assets to service it back in
line. The first approach was to hope that fiscal and monetary stimulus would buy time for asset prices to
stabilize and the debt servicing capability to rise (and that approach pretty much worked during the S&L
crisis of the late 80s and early 90s, although policy was then more focussed on finding market clearing
prices.). Until recently that muddle-through approach seemed to be working but the weak economic data of
the last two months and especially the last couple of weeks have put that in question. Recent inflation and
growth numbers, if anything, suggest that the gap between debt servicing capability and asset prices may be
rising rather than narrowing.
How will the USD respond?
Given the risk of falling into a double dip, a wide variety of unconventional responses are likely to be
discussed. The frustration with the potential long-term debt servicing costs of pure fiscal stimulus and the
concern that monetary policy on its own is pushing on a string may lead to discreet discussions of large and
more directly monetized fiscal policy. The advantage of the joint approach is that it works directly on
aggregate demand (and thus is not pushing on the proverbial string) and does not carry the long-term debt
servicing consequences of borrowing from the private sector (the Fed is printing money). The fiscal thrust

Figure 1. Treasuries bought in bulk by foreigners Figure 2. Inflation and low rates in post-WW2 US

4000
10 140

3500 9 10 yr treasury yield (left)

30 yr treasury yield (left) 130
8 CPI (1945=100)
3000

7 120
2500
6
USD bn

110
percent

Index

2000
5

1500 100
4

1000 3 90

2
500
80
1
0
1998-12 2000-12 2002-12 2004-12 2006-12 2008-12 0 70
1940-01 1942-01 1944-01 1946-01 1948-01

Source: US Treasury, Citi, as of 26 August 10 Source:: Ecowin, Citi, as of 26 August 10

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CitiFX® & LM Strategy August 26, 2010

could be embedded through the tax system or direct government spending.

That the monetized fiscal policy will likely increase inflation expectations and lead to selling of the USD by
foreigners is either an advantage or disadvantage depending on your perspective. If stronger activity and a
higher price level means that the private (and increasingly public) debt incurred over the last ten years could
be serviced, albeit with creditors taking an inflation-induced haircut, the imbalance between asset prices and
debt servicing capability could be unwound.
For those who think that the post-war period was the heyday of successful macroeconomic policymaking,
consider that the price level went up by 35% between the end of WW2 and mid-1948, while 10yr and 30-yr
Treasuries yielded about 2.0% (Figure 2). It is hard to argue that inflation has not reduced the real debt
burden in the past, and that risk will continue to weigh on the USD. If anything, the floating USD as opposed
to the fixed Bretton Woods USD of the late 1940s would aid in adjustment.
The combination of the Fed anchoring rates at the short end and supporting fiscal policy through balance
sheet expansion would certainly make it clear to foreign investors that the USD assets they are buying
(particularly the Treasuries) carry a degree of long-term risk. It would also signal that the US was willing to
inflate itself out of its debt problems
The long-term disadvantage is that monetary policy credibility would be lost for a long time, if not forever.
Borrowing costs would be higher at full employment and policy would be viewed as having exercised a
hyper-Greenspan put. The cost of lost long-term credibility is a real cost, even if somewhat difficult to
measure, but there is also a real gain from closing an output gap that is estimated to be in the 6-7% of GDP
range.
QE more effective than USD intervention
Renewed significant balance sheet expansion, particularly if viewed as implicitly monetizing government debt
is probably more effective than conventional intervention at weakening the USD. It is not straightforward to
intervene against (Asian) currencies that do not trade freely in capital markets. In fact it is close to
impossible, so standard steriliized intervention is not feasible.
Balance sheet expansion and QE are unsterilized injections into the financial sector and economy. Unlike hit
and run intervention, the impact is long-lasting and sends a clear message to foreign investors that the US
authorities are willing to alter the supply-demand balance for US assets. It does not directly prevent the
building up of USD reserves, but it alters the incentives for such accumulation when the risk is high that the
value of the accumulated reserves will drop. If US policy markers really think that the level of the USD is an
impediment to recovery, this is the ultimate credible signal that the US authorities are determined to force an
adjustment.
One implication is that the currencies that might appreciate the most are those of reserve managers (and
especially those with rapidly accumulating reserves) because they stand to lose directly from a large
increase of global US assets and they have the most concentrated holdings. Recall that 60-65% of global
reserves are still in USD. Private sector investors very likely are more diversified in their holdings.
Unorthodox policies to weigh on the USD
And what if US policymakers hold off on QE? Our US Economists see them as highly responsive, but not
fully convinced yet. In the near term, policy reticence is probably a USD plus, even if the mechanism is
through acute disappointment in US and global asset markets. However, as long as the growth that emerges
in the rest of the world is steady, even if at a lower pace than desired, the USD would likely come under
pressure, albeit more gradually.
It is difficult to gauge the set of policies that US policymakers will pursue to reduce the risk that the US
slumps into a significant slowdown. In the current environment of extremely disappointing growth and
apparent lack of response to traditional monetary stimulus, policies that are less than orthodox are likely to
be considered seriously. Most of these unorthodox polices are likely to weigh on the USD.

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CitiFX® & LM Strategy August 26, 2010

Global FX & Local Markets Strategy

G10
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