DOES CURRENCY INTERVENTION WORK?
The last few weeks have been a near perfect example of why Central Banks are destined to fail in their quest to devalue their currencies and create an export driven recovery. As the global race to the bottom heats up we are seeing increasing central bank activity from almost all corners of the globe. The most glaring was the BOJ/MOF intervention just a few weeks ago. The BOJ implemented what I referred to as a “short-term fix to a long-term problem”. Well, it turned out to be far more “short-term” than I even believed. Just a few weeks later the Yen is trading above its pre-intervention levels:
The problem of course, is that the entire global economy is hoping to keep their exchange rate low as they export their way to economic prosperity. The Chinese peg the Yuan to the dollar, the Japanese will maintain easy money as far as the eye can see, the Fed will ease to no end and the Europeans (who appear to be asleep at the wheel as the Euro surges) will almost certainly intervene in some fashion in the next few weeks or months. The problem is, this is all just a fancy sounding merry-go-round. Everyone can’t devalue at once. Despite the BOJ’s obvious failure in intervention the world appears to have an undying faith in Central Bankers who clearly don’t see that they are wasting time focusing on all the wrong problems. The global imbalances remain. The private sector problems very much remain. We can’t glaze over these problems via market manipulation. As Joseph Stiglitz said this morning, more likely, these bankers are making everything worse.
Ask the Russian’s, they will tell you.
A question:
Why and how does it work for China? Is it sustainable and if so for how long?
It seems to me that it can work for net exporters only. Alter all it makes no sense to make your money cheaper if you import more than what you export.
The Chinese are pegged. And no it is not sustainable because it creates imbalances. The Germans actually have a sort of soft peg (or the equivalent) because the Euro is a single current region and they are the net exporter. So they reap all the rewards no matter what happens. We’re now realizing in recession that these pegs and manipulations don’t help anyone. This is the imbalance that Stiglitz refers to in TPC’s other piece. It won’t end well.
Sorry, that does not explain it. I understand that they are pegged, but that has implications. In order to support the currency ratio they have to intervene. In this case to make their currency cheaper. The question is how do they do that, how much they lose to do it and how long can they keep doing it.
They can keep doing it as long as they keep importing enough dollars to peg the currency. The problem would be if the entire global economy slows more sharply and they actually see the need to devalue as well. Their mercantilist policies have added to the global economic problems and my guess is that none of this will truly end until China suffers.
Back in the day, the only CB we (fx traders) respected was The Bundesbank.
The others? Not so much. (‘cept maybe SNB ’till they jumped the shark).
And yet everyone and their mother gets paraded on TV talking about how great it is that the Fed is intervening in everything. They have SOO many tools left. Does no one read history books anymore? The Japanese are exhibit A that the Fed will fail.
LOL -this is too funny. Banana Ben seems to be quite successful at currency intervention, wouldn’t you say?
For the time being. Wait til Trichet steps up to the mic. TPC is right – the Europeans aren’t going to let Ben crush their fragile economy with a higher Euro.
Ben’s not succeeding. He’s simply applied another short-term solution to a long-term structural problem. He still has no grasp of the actual problems at hand. That’s why he keeps attempting these pointless fixes.
Has been ever succeeded at anything? Besides saving all of his banking buddies in 2009?
Ben that is.
TPC,
Your assertion is that Central Bankers won’t/can’t succeed at currency manipulation. You use the BOJs recent failure as an example. Well, pull up a chart of the .DXY and tell me that Banana Ben has been unsuccessful at debasing the currency. He has been exceedingly succesfull. In fact, Banana Ben is so good that he does not actually have to perform QE2, rather all he has to do is talk about QE2, and he gets the desired outcome.
Now, is this going to do anything for the real economy? No, probably not. But your assertion is that Banana Ben and other CB’s can not successfully manipulate their currency and Banana Ben is demonstrating that to be simply “False” everyday.
Let’s not take things out of context so you can try to prove your 1 month point. The fact is, the Fed has been on a campaign of QE since late 2008. Have they succeeded in crushing the dollar? You tell me:
The point I have long argued is that these acts are futile. The Japanese have been manipulating their currency for 20 years. The USA and the Fed have been manipulating interest rates for 20 years believing that they are all powerful.
It turns out that the Fed has a lot less control than anyone thinks. They haven’t done anything. Ben convinced Congress to save his banking friends. That’s all he did. It cause a mean reversion rally. Big deal. It didn’t solve any of the problems. Now he’s trying to talk up the market while ignoring all the real problems.
He reminds me of every BOJ governor that has been in power over the last few decades.
I would say it was humorous if Ben’s obliviousness wasn’t hurting so many people.
OK, true. But in the periods where Banana Ben was printing to buy assets, the dollar was trashed and assets went vertical. And in the periods where Banana Ben stopped printing and buying, the dollar moved higher and assets moved sideways/down.
So, to the extent that Banana Ben is on a mission to levitate asset values via printing and buying, and trashing the currency, he appears to be successful.
Again, will that do anything for the real economy? No. But will it levitate assets at absurd values out of any and all relationship to real asset values? Yes, most likely.
What is Ben “printing”? QE does not create net new financial assets. All Ben did during the crisis was save the banks. Yes, that helped boost the rally and alleviated the credit markets (via the asset swap), but he did not “print money”. In fact, you could argue that Ben has been a roadblock during the recovery as he removed over $50B in interest payments from the private sector and replaced it with 0.25% paper. That’s deflationary and actually contracts the money supply as it serves as a tax on the private sector.
This is the whole flaw with the inflationist thinking. Why is inflation well below the historical average if so much money has been printed? Inflationists still can’t answer this question.
TPC,
He prints money. Cash. Digits. Yes, I know, it creates no net new financial assets. But it does put cash on the books at the expense of a treasury. so what does a PD do? They deploy that cash, lever it up and buy stocks. It is a self fulfilling prophecy. You are right, it is bogus, the assets’ are intrinsic value (DCF to equity) is worth no more at t+1 than it was at t-1, but it does not matter; they bid up the assets. That is why I said Banana Ben is levitating assets at extreme overvaluations. The proof of the pudding is in the eating. During periods of POMO QE1, QE lite, and ultimately QE2, asset prices go up. Not intrinsic value, but market price
and since the QE inflates asset prices, even if it does not effect intrinsic value, it DOES increase net financial assets in the private sector because the market capitalization of equities (and bonds) increases. Ergo, increase in net financial assets. Which is what Banana Ben is after in the first place. Increase asset prices, cross his grubby sore fingers and hope some of that new-found “value” makes its way into the real economy
That’s conspiracy theory chatter. If you sell your bonds to the Fed and you decide to change your risk profile and go buy stocks you still have to find a willing seller of equal size. It’s the old cash on the sidelines argument. Do you really think these banks are just rushing into equities at a premium when they know damn well that their books are still in tatters?
The banks are not changing their risk profile for the most part. They are not selling bonds and moving into equities en masse. You can see the reserves on their books. They are all there earning 0.25%. The banks are not running out and buying Amazon and Apple stock like so many people say they are. They could have done that before. Nothing was stopping them. The fact that the Fed swapped their bonds with cash did not make them more willing to buy stocks. That’s nonsense.
The change in asset values is due to the changing curve structure which makes equities more attractive. These banks aren’t just running out and altering their risk profile for the hell of it.
TPC,
so you are saying that QE lowers interest rates “changing curve structure”. OK. The “fair” P/E is [Rf + Rp]^-1 so if Rf declines because of QE then the “fair” P/E increases, which drives equity prices up, which increase the net financial assets of the private sector.
So while QE may not increase asset prices through a change in “risk profile”, it does increase asset value and prices through a reduction in interest rates.
So, again, while Banana Ben may not be able to fix the structural problems in the economy with his QE, he can inflate asset prices (and value) if he can lower interest rates, and in turn he hopes that this “papering over” of the structural problems will trickle down into the real economy.
Look, I’m not supportive of this – I refer to him as Banana Ben – but if he is going to drive up asset values through his endless QE then it is a major consideration for investors. And if it is via a reduction in the risk free rate, then that is a “legitimate” increase in value, not just price.
Now, having said that, I will say that my estimate on fair value for the S&P500 is 800-850, even with Banana Ben’s QE
Aha! Now you’re onto something and this is the real crux of the debate. Will lower interest rates (in the case of QE marginally lower than they are now) alleviate the pressures at the private sector level that creates sufficient growth in corporations to justify higher valuations?
I would argue that lower interest rates in this environment have a lesser impact than most assume. This is my whole balance sheet recession and the idea that the Fed is largely impotent as they can’t create demand for debt and alleviate debt levels sufficiently to generate sustained strong economic growth.
I could be entirely wrong here, but I think equities are beginning to price in a fairly rosy economic outcome based on lower rates.
Thoughts?
Well, all else equal, my description above implies that QE need not influence future aggregate SP500 cash flow to equity by one penny, because the reduction in the risk-free rate increases the “fair” P/E. I.e, a higher (present value) valuation of identical future cash flows merely via a reduction in the discount rate. Any trickle down to the real economy that would increase future cash flows would only add to the fair market price via an increase in the “E” within price = “E”*P/E
I agree with you that lower interest rates are not going to spur lending and growth (“E”), thus the only legitimate Q/E influence on asset prices is via P/E. And with rates already so low, a 20 or 30 bp decine in the risk free rate has only modest impact on the normal P/E as the risk premium is 400-450 bps and the base risk free is 350 bps
I disagree with the last assertion of your argument TPC…
If lower interest rates yielded higher DCF values and stock prices why did we begin the last decade with the 10 yr at 6% only to produce a 40% decline in stocks through the end of 2009 all while the 10 year sank nearly 400 bps??
Why are equities stil down by 25% off the 2000 highs if that argument carried any weight?
We agree Ferro. I am not saying that lower rates will ignite higher returns in equity prices. In fact, I am saying that lower rates have little to no impact in this environment.
Aren’t rates going lower without QE anyway? QE only quickens the process. Look at the nice correlation chart between stocks and bond yields. Since 2000 lower yileds have meant lower stocks valuations, because although the discount rate is lower, the economy and thus earnings growth rates are also lower.
Also: the ERP is by no way constant.
See:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669398
TPC,
I said all else equal. By definition, a lower risk free rate gives a higher present value of future cash flow. that is just mathematics. so if QE lowers the risk free rate, and nothing else changes, then the present value of those unchanged future cash flows is higher.
your point is that QE is not going to have a positive impact on those future cash flows. Fine, I agree with that. and obviously a meaningful increase in future cash flows would have a more favorable impact to present values than a modest reduction in the risk free rate
the currency war itself showed how low intelligence and how short sighted right now the central banks become, globally. I totally lost any confidence with them.
of course the US started it, and should bear with the blame if instability happens globally.
Things are getting worse. It’s interesting to see the equity markets continue to melt higher. It’s almost like you can see the disconnect here as people buy into the idea that central bankers will make everything better. Meanwhile, yields continue to drop. The bond market is very scared about future growth.
Lure, tempt the retail investors in with no brainer QE2 equity melt-up trade and then BAM!
Fireworks baby! We’re going to be waking up to the 4th of July ever day over the coming year(s).
I love the markets!
TPC– I guess one question that jumps out is where SHOULD the dollar be relative to other currencies. I mean, everyone can’t devalue at the same time, and previous attempts to lower the dollar have been relatively short lived, as can be seen in the chart you posted. Do you think the dollar is a trade here? It LOOKS oversold, but who the hell knows what’s it actually worth? It’s not like you can apply a DCF analysis to it. Is that even an answerable question?
Yes, hard to say what a currency is worth. You can run PPP’s until the cows come home, but trading or investing off that is largely useless.
Then again, the ten year chart doesn’t give me a warm feeling towards the dollar at all.
TPC,
when the Fed executes QE they are not changing net financial assets of private sector; i got that. they are only changing the composition. What about the so called “money supply”? Are bank reserves part of the money supply? So when the fed executes QE – let’s say they swap $1,000 in bank reserves for a $1,000 treasury note – does that increase the “official” money supply by $1,000?
I ask, because our prior discussion seemed to converge on idea that QE is not going to influence lending, only interest rates, and it is fractional reserve lending that creates new money. So you and I seem to be saying there is no incremental money, just lower interest rates, as we assert no incremental lending. but does the act of QE “create money” in the context of officially reported money supply, and is that why people believe there is so much “printing”?
I’ve posted this before, but it should be helpful:
Hoisington summed my thinking up beautifully in a recent paper:
“The monetary base, bank reserves plus
currency, does not fulfill these functions and hence
does not constitute money. To paraphrase Friedman
and Schwartz, the base, which is also known as highpowered
money (currency in the hands of the public
and assets of banks held in the form of vault cash
or deposits at Federal Reserve Banks) cannot meet
these criteria. The nonbank public – nonfinancial
corporations, state and local governments and
households – cannot use deposits at the Federal
Reserve Bank to effectuate transactions. Moreover,
currency is not sufficiently broad to be considered a
temporary abode of purchasing power. For Friedman,
high-powered money can be properly regarded as
assets of some individuals and liabilities of none.
So, let us be clear on this subject. In 2008, when the
fed purchased all manner of securities, to the tune of
about $1.2 trillion, the fed was not “printing money”.
Bank deposits at the fed exploded to the upside, the
monetary base rose from $800 billion to $2.1 trillion,
yet no money was “printed”. Deposits did not rise,
loans were not made, income was not lifted, and
output did not surge. The fed could further “quantative
ease” and purchase another $1 trillion in securities
and lift the monetary base by a similar amount yet
money would still not be “printed”.
So you can see, there has been no change in the net financial assets of the private sector. Ben is trying to talk the market up and he is succeeding so far. But he can’t talk the real economy up and that is why this program is destined to fail just like it did in Japan.
thanks TPC. So the answer is “yes”, people “see” an “exploding money supply”, but it is meaningless absent lending. Reserves sitting at the Fed don’t accomplish anything; just “apples on the shelf”.
Most useful financial site on the web, in my view. Narrower focus, not high quantity, but everything well thought out, great dialogue and debate, no BS. Half the stuff out there is such garbage, unsupported other than with hyperbole.
Do you have a link for the original version of this post, so that I can read in broader context?
Pod,
No need to thank me.
You’re exactly right. People see the Fed’s balance sheet exploding and say: well where is all that money coming from! It must be inflation!” In reality, the money is kind of like a void. It didn’t go into the economy. So you can see why I am skeptical of the efficacy of QE and why it didn’t actually do much in Japan.
The full Hoisington text is here:
http://www.hoisingtonmgt.com/pdf/HIM2010Q2NP.pdf
Thanks for sticking with me. I am not trying to be difficult or stubborn, but these concepts aren’t always easy to get across.
TPC,
are you saying that the reserves cannot be spent by the banks for some technical reason (e.g. they are not dollars) or are you saying that they just do not matter as long as they are not used for backing up lending (or possibly buying stocks or whatever)?
The funny part about all this nonsense of currency devaluation in order to increase exports is that the US wants to export to countries that are calling for austerity. If the Europeans are truly cutting spending as they claim, then they will be going into recession. No help there. China depends on the US market. No help there. Is Japan really going to be our savior? Look at their economy. It would seem that people in high places would think about how every country in the world is going to export its way to recovery.