Is the Greenback Heading for Greener Pastures Soon?

Dirty Money

Mr. Market has had one eye on the U.S. Federal Reserve for so long it may get stuck there — which, at a glance, could be fine.

Over the past couple of years the Fed has evolved from a monetary institution trying not to step on the toes of the free market (think Greenspan Doctrine) into something of a cross between a financial watchdog and monetary guide dog. Through its currently highly accommodative policy, particularly its program of quantitative easing, the Fed is attempting to stimulate market and economic activity by effectively lowering the cost of money and increasing the availability of credit. On the other hand, the Fed is also trying to make sure that all this easy money doesn’t inadvertently inflate the very same asset bubbles whose collapse contributed to the late 2000s crisis.

The Fed, to put it one way, has had its foot slammed on the monetary gas pedal since 2008, when QE 1 — a program to purchase $600 billion in mortgage-backed securities — went into effect. This and subsequent programs — the current iteration has the Fed purchasing $85 billion in longer-term securities and MBS each month — has increased the Fed’s balance sheet to more than $3.5 trillion.

If the size of the Fed’s balance sheet sounds obscenely massive, that’s because it is. The Fed’s ongoing QE program is unprecedented, and although it has played a critical role in providing fuel for the post-crisis recovery in the U.S., modest though it has been, it has also perverted financial incentive structures and distorted markets.

The Fed’s bond-buying program has been particularly stimulating for equity markets, which have been routinely refreshing all-time highs recently. The comparison may be stretched, but QE has acted like amphetamine for the stock market, and just the idea of the Fed tapering purchases has sent the markets careening downwards. This is why Mr. Market has had his eye fixed on the Fed for so long — QE won’t last forever, and its wind down will have an effect on equity valuation and investing behavior.

So when will the Fed begin to taper purchases? The Federal Reserve Open Market Committee could make an announcement as early as September following its meeting the 18-19 of that month. Policymakers have set thresholds for policy decisions based on economic indicators — a 6.5 percent headline employment rate with a “speed limit” of 2.5 percent inflation, which we are nowhere near — and all those indicators may finally be saying the time is now.

The impact of this tapering will affect not just the equity markets but the currency markets, as well. In general, QE devalues the currency of whichever central bank engages in the program. This has been particularly apparent with the Bank of Japan and the yen, which weakened dramatically on the back of the nation’s stimulus program.

USD-JPY Currency Conversion Chart - Yahoo! Finance

Earlier in July, the value of the U.S. dollar as measured by The Wall Street Journal’s Dollar Index had climbed 8.3 percent for the year to a three-year high. The gain was led by speculation regarding the Fed’s withdrawal from its QE program. As noted, when the Fed begins to wind down purchases, effectively reducing the flow of new money into the economy, the value of the dollar would increase.

At the same time, this would send a signal to the markets that the U.S. economy is improving, which could drive up the dollar even further. All in all, a pretty good position for someone who is long on the dollar. For much of the beginning of 2013, this seemed to be the thinking of many currency traders: pile into the dollar; wait for tapering and economic improvement; profit.

But the value of the dollar — i.e., the health of the economy and the Fed’s taper timeline — has been anything but clear and consistent, fueling a fairly volatile currency market over the past few months.

WSJ Dollar Index

Source: Data from The Wall Street Journal

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