The Chinese yuan has appreciated by more than 27.5% since 2005, when the People’s Bank of China (“PBOC”) formally acceded to international pressure and began to relax the yuan-dollar peg. For China-watchers and economists, that the Yuan will continue to appreciate is thus a given. There is no question of if, but rather of when and to what extent. But what if the prevailing wisdom is wrong? What if the yuan is now fairly valued, and economic fundamentals no longer necessitate a further rise?
Prior to the 2005 revaluation, economists had argued that the yuan (also known as the Chinese RMB) was undervalued by 15% – 40%, and American politicians had used this as a basis for proposing a 27.5% across-the-board tariff on all Chinese imports. Given that the yuan has now appreciated by this exact margin (and by even more when inflation is taken into account), shouldn’t this alone be enough to silence the critics, without even having to look at the picture on the ground? How can Senator Charles Schumer continue to press for further appreciation when the yuan’s rise exceeds his initial demands? Alas, election season is upon us, and we can’t hope to make political sense out of this issue. We can, however, attempt to analyze the economic sense of it.
With this in mind, why would the PBOC even think about allowing the RMB to appreciate further? According to one perspective, the narrowing trade imbalance is only temporary. When commodities prices settle and global demand fully recovers, a wider trade surplus will follow. In fact, the IMF forecasts China’s current surplus will rise to 8% by 2016. As you can see from the chart below (courtesy of The Economist), however, the IMF’s forecasts have proven to be too pessimistic for at least the last three years, and it now has very little credibility. Besides, China’s economy is gradually reorienting itself away from exports and towards domestic spending. As a resident of China, I can certainly attest to this phenomenon, and the last few years has seen an explosion in the number of cars on the road, domestic tourism, and conspicuous consumption.
A better argument for further RMB appreciation comes in the form of inflation. At 5.4%, inflation is officially nearing a 3-year high, and there is evidence that the PBOC already recognizes that allowing the RMB to keep rising represents its best tool for containing this problem. It has already raised banks’ required reserve ratio several times, but there is a limit to what this can accomplish. Meanwhile, the PBOC remains reluctant to raise interest rates because it will invite further “hot-money” inflows (estimated at more than $100 Billion per year, if not much higher) and potentially destabilize the banking sector. By raising the value of the yuan, the PBOC can blunt the impact of rising commodities prices and other inflationary forces.
For the record, I think that the Chinese yuan is pretty close to being fairly valued. That might seem like a ridiculous claim to make when Chinese wages and prices are still well below the global average. Consider, however, that the same is true for the majority of emerging market economies, including those that don’t peg their currencies to the dollar. That doesn’t mean that the yuan won’t – or that it shouldn’t – continue to rise. In fact, the PBOC needs to do more to ensure that the Yuan appreciates evenly against all currencies, since most of the yuan’s rise to-date has taken place relative to the US Dollar. It’s merely a commentary that the PBOC is close to fulfilling the promises it has made regarding the yuan, and going forward, I think that observers should expect that its forex policy will be reconfigured to promote domestic macroeconomic policy objectives.
Dollar will Rally when QE2 Ends
In shifting their focus to interest rates, forex traders have perhaps overlooked one very important monetary policy event: the conclusion of the Fed’s quantitative easing program. By the end of June, the Fed will have added $600 Billion (mostly in US Treasury Securities) to its reserves, and must decide how next to proceed. Naturally, everyone seems to have a different opinion, regarding both the Fed’s next move and the accompanying impact on financial markets.
The second installment of quantitative easing (QE2) was initially greeted with skepticism by everyone except for equities investors (who correctly anticipated the continuation of the stock market rally). In November, I reported that QE2 was unfairly labeled a lose-lose by the forex markets: “If QE2 is successful, then hawks will start moaning about inflation and use it as an excuse to sell the Dollar. If QE2 fails, well, then the US economy could become mired in an interminable recession, and bears will sell the Dollar in favor of emerging market currencies.”
The jury is still out on whether QE2 was a success. On the one hand, US GDP growth continues to gather force, and should come in around 3% for the year. A handful of leading indicators are also ticking up, while unemployment may have peaked. On the other hand, actual and forecast inflation are rising (though it’s not clear how much of that is due to QE2 and how much is due to other factors). Stock and commodities prices have risen, while bond prices have fallen. Other countries have been quick to lambaste QE2 (including most recently, Vladimir Putin) for its perceived role in inflating asset bubbles around the world and fomenting the currency wars.
Personally, I think that the Fed deserves some credit- or at least doesn’t deserve so much blame. If you believe that asset price inflation is being driven by the Fed, it doesn’t really make sense to blame it for consumer and producer price inflation. If you believe that price inflation is the Fed’s fault, however, then you must similarly acknowledge its impact on economic growth. In other words, if you accept the notion that QE2 funds have trickled down into the economy (rather than being used entirely for financial speculation), it’s only fair to give the Fed credit for the positive implications of this and not just the negative ones.
But I digress. The more important questions are: what will the Fed do next, and how will the markets respond. The consensus seems to be that QE2 will not be followed by QE3, but that the Fed will not yet take steps to unwind QE2. Ben Bernanke echoed this sentiment during today’s inaugural press conference: “The next step is to stop reinvesting the maturing securities, a move that ‘does constitute a policy tightening.’ ” This is ultimately a much bigger step, and one that Chairman Bernanke will not yet commit.
As for how the markets will react, opinions really start to diverge. Bill Gross, who manages the world’s biggest bond fund, has been an outspoken critic of QE2 and believes that the Treasury market will collapse when the Fed ends its involvement. His firm, PIMCO, has released a widely-read report that accuses the Fed of distracting investors with “donuts” and compares its monetary policy to a giant Ponzi scheme. However, the report is filled with red herring charts and doesn’t ultimately make any attempt to account for the fact that Treasury rates have fallen dramatically (the opposite of what would otherwise be expected) since the Fed first unveiled QE2.
The report also concedes that, “The cost associated with the end of QEII therefore appears to be mostly factored into forward rates.” This is exactly what Bernanke told reporters today: “It’s [the end of QE2] ‘unlikely’ to have significant effects on financial markets or the economy…because you and the markets already know about it.” In other words, financial armmagedon is less likely when the markets have advanced knowledge and the ability to adjust. If anything, some investors who were initially crowded-out of the bond markets might be tempted to return, cushioning the Fed’s exit.
If bond prices do fall and interest rates rise, that might not be so bad for the US dollar. It might lure back overseas investors, grateful both for higher yields and the end of QE2. Despite the howls, foreign central banks never shunned the dollar. In addition, the end of QE2 only makes a short-term interest rate that much closer. In short, it’s no surprise that the dollar is projected to “appreciate to $1.35 per euro by the end of the year, according to the median estimate of 47 analysts in a Bloomberg News survey. It will gain to 88 per yen, a separate poll shows.”
The jury is still out on whether QE2 was a success. On the one hand, US GDP growth continues to gather force, and should come in around 3% for the year. A handful of leading indicators are also ticking up, while unemployment may have peaked. On the other hand, actual and forecast inflation are rising (though it’s not clear how much of that is due to QE2 and how much is due to other factors). Stock and commodities prices have risen, while bond prices have fallen. Other countries have been quick to lambaste QE2 (including most recently, Vladimir Putin) for its perceived role in inflating asset bubbles around the world and fomenting the currency wars.
But I digress. The more important questions are: what will the Fed do next, and how will the markets respond. The consensus seems to be that QE2 will not be followed by QE3, but that the Fed will not yet take steps to unwind QE2. Ben Bernanke echoed this sentiment during today’s inaugural press conference: “The next step is to stop reinvesting the maturing securities, a move that ‘does constitute a policy tightening.’ ” This is ultimately a much bigger step, and one that Chairman Bernanke will not yet commit.
As for how the markets will react, opinions really start to diverge. Bill Gross, who manages the world’s biggest bond fund, has been an outspoken critic of QE2 and believes that the Treasury market will collapse when the Fed ends its involvement. His firm, PIMCO, has released a widely-read report that accuses the Fed of distracting investors with “donuts” and compares its monetary policy to a giant Ponzi scheme. However, the report is filled with red herring charts and doesn’t ultimately make any attempt to account for the fact that Treasury rates have fallen dramatically (the opposite of what would otherwise be expected) since the Fed first unveiled QE2.
The report also concedes that, “The cost associated with the end of QEII therefore appears to be mostly factored into forward rates.” This is exactly what Bernanke told reporters today: “It’s [the end of QE2] ‘unlikely’ to have significant effects on financial markets or the economy…because you and the markets already know about it.” In other words, financial armmagedon is less likely when the markets have advanced knowledge and the ability to adjust. If anything, some investors who were initially crowded-out of the bond markets might be tempted to return, cushioning the Fed’s exit.
If bond prices do fall and interest rates rise, that might not be so bad for the US dollar. It might lure back overseas investors, grateful both for higher yields and the end of QE2. Despite the howls, foreign central banks never shunned the dollar. In addition, the end of QE2 only makes a short-term interest rate that much closer. In short, it’s no surprise that the dollar is projected to “appreciate to $1.35 per euro by the end of the year, according to the median estimate of 47 analysts in a Bloomberg News survey. It will gain to 88 per yen, a separate poll shows.”
Forex Markets Focus on Central Banks
Over the last year and increasingly over the last few months, Central Banks around the world have taken center stage in currency markets. First, came the ignition of the currency war and the consequent volley of forex interventions. Then came the prospect of monetary tightening and the unwinding of quantitative easing measures. As if that wasn’t enough to keep them busy, Central Banks have been forced to assume more prominent roles in regulating financial markets and drafting economic policy. With so much to do, perhaps it’s no wonder that Jean-Claude Trichet, head of the ECB, will leave his post at the end of this year!
The currency wars may have subsided, but they haven’t ended. On both a paired and trade-weighted basis, the Dollar is declining rapidly. As a result, emerging market Central Banks are still doing everything they can to protect their respective currencies from rapid appreciation. As I’ve written in earlier posts, most Latin American and Asian Central Banks have already announced targeted strategies, and many intervene in forex markets on a daily basis. If the Japanese Yen continues to appreciate, you can bet the Bank of Japan (perhaps aided by the G7) will quickly jump back in.
You can expect the currency wars to continue until the quantitative easing programs instituted by the G4 are withdrawn. The Fed’s $600 Billion Treasury bond buying program officially ends in June, at which point its balance sheet will near $3 Trillion. The European Central Bank has injected an equally large hunk of cash into the Eurozone economy. Despite inflation that may soon exceed 5%, the Bank of England voted not to sell its cache of QE assets, while the Bank of Japan is actually ratcheting up its program as a result of the earthquake-induced catastrophe. Whether or not this manifests itself in higher inflation, investors have signaled their distaste by bidding up the price of gold to a new record high.
Then there are the prospective rate hikes, cascading across the world. Last week, the European Central Bank became the first in the G4 to hike rates (though market rates have hardly budged). The Reserve Bank of Australia, however, was the first of the majors to hike rates. Since October 2009, it has raised its benchmark by 175 basis points; its 4.75% cash rate is easily the highest in the industrialized world. The Bank of Canada started hiking in June 2010, but has kept its benchmark on hold at 1% since September. The Reserve Bank of New Zealand lowered its benchmark to a record low 2.5% as a result of serious earthquakes and economic weakness.
Going forward, expectations are for all Central Banks to continue (or begin) hiking rates at a gradual pace over the next couple years. If forecasts prove to be accurate, the US Federal Funds Rate will stand around .5% at the beginning of 2012, tied with Switzerland, and ahead of only Japan. The UK Rate will stand slightly above 1%, while the Eurozone and Canadian benchmarks will be closer to 2%. The RBA cash rate should exceed 5%. Rates in emerging markets will probably be even higher, as all four BRIC countries (Russia, Brazil, China, India) should be well into the tightening cycles.
On the one hand, there is reason to believe that the pace of rate hikes will be slower than expected. Economic growth remains tepid across the industrialized world, and Central Banks are wary about spooking their economies with premature rate hikes. Besides, Fed watchers may have learned a lesson as a result of a brief bout of over-excitement in 2010 that ultimately led to nothing. The Economist has reported that, “Markets habitually assign too much weight to the hawks, however. The real power at the Fed rests with its leaders…At present they are sanguine about inflation and worried about unemployment, which means a rate rise this year is unlikely.” Even the ECB disappointed traders by (deliberately) adopting a soft stance in the press release that accompanied its recent rate hike.
On the other hand, a recent paper published by the Bank for International Settlements (BIS) showed that the markets’ track record of forecasting inflation is weak. As you can see from the chart below, they tend to reflect the general trend in inflation, but underestimate when the direction changes suddenly. (This is perhaps similar to the “fat-tail” problem, whereby extreme aberrations in asset price returns are poorly accounted for in financial models). If you apply this to the current economic environment, it suggests that inflation will probably be much higher-than-expected, and Central Banks will be forced to compensate by hiking rates a faster pace.
Finally, in their newfound roles as economic policymakers, Central Banks are increasingly engaged in macroprudential policy. The Economist reports that, “Central banks and regulators in emerging economies have already imposed a host of measures to cool property prices and capital inflows.” These measures are worth watching because their chief aim is to indirectly reduce inflation. If they are successful, it will limit the need for interest rate hikes and reduce upward pressure on their currencies.In short, given the enhanced ability of Central Banks to dictate exchange rates, traders with long-term outlooks may need to adjust their strategies accordingly. That means not only knowing who is expected to raise interest rates – as well as when and by how much – but also monitoring the use of their other tools, such as balance sheet expansion, efforts to cool asset price bubbles, and deliberate manipulation of exchange rates.
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