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Blessed are the weak (currencies)

Thu, Nov 12 2009, 05:55 GMT
by UniCredit Research

UniCredit Group

With interest rate differentials across the major developed regions wiped out by the simultaneous adoption of ZIRP, the major crosses are moving in sympathy with the need to reduce global imbalances—even while swings in risk appetite remain the key driver of the USD crosses. And weak currencies have the implicit blessing of the respective policymakers, and of international institutions like the IMF. This is not a case of beggar-thy-neighbor, as neither the US nor the UK are deliberately pursuing a weak currency—but the accommodative policy stance required by domestic condition will continue to undermine sterling and the USD, while the Eurozone will have to learn to live with a strong euro for most of next year as well.

Presenting the November Inflation Report today, Bank of England Governor King implicitly gave his blessing to the weak sterling, highlighted as one of the key drivers of the projected recovery. He also suggested that prolonged sterling weakness would be welcome, noting that the UK needs to rebalance its growth model towards higher net exports and away from domestic demand, while consumers and corporates repair their balance sheets.

In a similar vein, Dallas Fed President Fisher yesterday noted that the USD is undergoing a “rather orderly depreciation,” that is one that does not warrant a reaction by US policymakers. His comments dovetailed nicely with the IMF’s view that the USD is still overvalued on a real effective basis—a view published on the eve of last week’s G20.

With interest rate differentials across the major developed regions wiped out by the simultaneous adoption of ZIRP, the major crosses are moving in sympathy with the need to reduce global imbalances—even while swings in risk appetite remain the key driver of the USD crosses. Hence, sterling and the greenback remain weak, in line with the need of the US and the UK to reduce their external imbalances further and set domestic consumption on a more sustainable path. The euro meanwhile remains strong, reflecting both the eurozone’s vaunted lack of external imbalances as well as China’s reluctance to allow the yuan to appreciate.

For all the talk about exit strategies, I believe economic policies will support this configuration of FX rates for some time—in particular, the eurozone will have to adjust to living with a strong euro for most of next year as well. It is not that the US and UK are willfully pursuing a weak currency—it is just that domestic conditions still require a prolonged accommodative stance that will undermine the respective currencies until the recovery picks up pace.

The BoE’s inflation report was very clear in this regard, striking a dovish tone and reminding us that quantitative easing is still needed to push investors to diversify into assets yielding a higher return. And, as Governor King put it, “…that in turn will boost the prices of those assets, reducing yields and the cost to companies of raising funds in financial markets. Ultimately, that will help stimulate spending, smooth the necessary rebalancing of the economy, and keep inflation close to the target.” We have heard similar comments from Fed officials in the recent past: zero interest rates and abundant liquidity have been deliberately targeting some measure of asset price re-flation as a way to help get the financial sector back on its feet, improve financing conditions, rebuild confidence and revive consumption. With the recovery in both countries still fragile (and barely beginning in the UK), accommodative policies are set to remain in place for quite a while longer, given that inflation risks are not yet on the radar screen: as King noted, "Despite a recovery in economic growth, output is unlikely, at least for a considerable period, to return to a level consistent with a continuation of its pre-crisis trend." This reflects a reduction in potential growth ("the impact of the downturn on the supply capacity of the economy is expected to persist", but also the fact that growth will fall short even of this reduced potential for some time ("there is likely to be sustained weakness of demand relative to that capacity.") In other words, even as growth recovers a sizable output gap will persist, keeping a lid on inflation pressures. This King said, is "the big picture", one that should allow both UK and US to continue enjoy weak currencies for a while.

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Published on  Thu, Nov 12 2009, 06:00 GMT