In this month’s Market View we look at the Fed’s quantitative easing policy, discuss continuing fluctuations in the swap spread and consider how EUR/GBP is likely to develop later this year.
Last month, the Fed announced the beginning of a quantitative easing (QE) policy, aimed at increasing the money supply in the economy and driving down mortgage lending rates. Furthermore, Fed chairman Ben Bernanke said the Fed would, when necessary, directly buy longer term bonds in the open market in order to drive down long-term interest rates and to stimulate growth.
Given today’s ill-functioning credit markets where more companies and households are cut off from cheap and easy credit every day, a QE policy might ultimately be the only solution. It bypasses the hampered banking system and scared investors and ensures that financially healthy businesses and households have access to credit.
A sufficiently large QE policy might therefore break the downward spiral of declining asset prices, bigger losses for banks, tighter credit standards and less lending, slower growth and declining asset prices.
However, there are a number of caveats:
QE increases the risk of higher inflation. In the short-term, the risks are limited as the current QE policy is intended as a substitute for lending which was previously done by banks and investors. Although the amount of money in the system is rising fast, aggregate upward pressure on inflation remains limited. Furthermore, the world economy is in recession, eliminating virtually all inflation risks. However, in the longer term – when the US economy recovers and banks begin to function ‘normally’ again – the increased money supply could increase the inflation rate quite easily and rapidly. Anticipating this, bond investors could start to demand higher yields to compensate for this higher risk.
If the Fed is the first central bank to start a QE policy in full, foreign investors could lose trust in the value of the dollar. Depending on foreign capital inflow, the US will be seriously affected by this.
The aforementioned risks imply that the Fed must be very careful with respect to QE. A sharp fall in the dollar or a rapid rise in long-term interest rates (or inflation expectations) would mean the Fed has gone too far and that another, more serious, economic and/or dollar crisis is looming.
Therefore, we think that as long as the Fed is the only important central bank engaged in QE policies, the Fed will not risk another crisis and will therefore limit the extent to which QE is applied. We fear this will curb the ability of the Fed so much that, after a relatively short period of relief, financial markets will discount a continuation of the downward spiral. In 2009, on balance we therefore expect lower equity prices and stubbornly high credit spreads.
Swap rates and bank nationalisations
Normally, the Interest Rate Swap (IRS) curve is above the government bond yield curve, reflecting a higher risk associated with inter-bank lending compared to lending to governments. The spread between the two curves (the swap spread) did not fluctuate a lot before the start of the credit crisis in July 2007. Consequently, the cost of borrowing for any company was dependent on its own risk premium and the yield on government bonds.
However, since the start of the credit crisis IRS rates have increased significantly and government yields decreased substantially as investors worldwide have fled to safe havens. This makes fluctuations of the swap spread another important variable for total lending costs. Meanwhile, governments and central banks are supporting troubled banks sufficiently to guarantee their business is a ‘going concern’. This means that the risk associated with inter-bank lending decreases, pushing down the IRS rates. At the longer end of the curve (30 years and 50 years) the swap spread is – at the time of writing – even negative, reflecting intense demand from pension funds for longer term IRS to hedge against a further decline in long-term interest rates.
Besides this anomaly, the decline in swap rates should, in our view, continue as long as governments backstop commercial banks and panic subsides. However, this year we expect another round of stock market declines and rising credit spreads, as a consequence of rising worries about whether or not the stimulus packages by the fiscal and monetary policies are working sufficiently well.
Swap rates could widen when fears of bank failures rise again. This will continue until governments again make clear that they will do everything to save banks which are deemed too big to fail. Outright nationalisation will then become increasingly likely. From that point, we expect the swap spreads to decline to pre-crisis levels.
Is sterling undervalued or euro overvalued?
Last year, sterling weakened most in the highly volatile G7 currency markets. EUR/GBP in 2008 for example, extended the rally from 0.67 mid-2007 to close to 0.95 last month. There are some explanations for this rapid rise:
The UK inflated its property and credit bubble the most of all Western economies, yielding rapid growth and low unemployment. Now that both bubbles are bursting, the negative consequences are being felt most in the UK with rapidly slowing growth, rising unemployment and aggressive rate cutting by the Bank of England.
With London as the world’s premier financial centre, the UK economy benefitted handsomely from the exploding growth in credit and financial transactions worldwide. This has changed and banks are now laying off employees as profits drop.
British banks are relatively more exposed to emerging markets than other European banks. As growth and asset prices of emerging economies have declined substantially, losses from investments and loans in and to these countries are growing.
Even though the economic situation appears to be more dire in the UK than in the rest of Europe, we expect a significant correction (or decline) in EUR/GBP for a couple of reasons.
First of all, much of the negative outlook for the British economy is already reflected in the weaker pound. For the pound to weaken further, the situation has to worsen beyond the already beaten down expectations, which virtually translates into a complete collapse of the economy. This, however, is unlikely given the large scale of the monetary and fiscal stimulus packages by the British authorities. Secondly, exchange rates are all about relative changes. In the coming months to quarters we expect – relative to current expectations – greater deterioration in the Eurozone economy than in the UK economy. In our view, much of this is a result of the inability of European governments to work together to present a co-ordinated fiscal stimulus package. In comparison, the UK government is more decisive.
To compensate for the inability of European governments to stimulate fiscally, we expect more interest rate cuts by the ECB. In our view, more rate cuts by the ECB and a deteriorating Eurozone economy will result in a temporary decline in EUR/GBP – from close to 0.95 we expect a decline towards 0.82 and possibly to 0.77.