Thursday, April 11, 2013

G4 central banks and the New Zealand dollar

G4 central banks are continuing to pull out all the stops to support economic growth and reflation in their respective economies.  In the past few days we have seen confirmation of the expected aggressive monetary easing in Japan, European Central Bank and Bank of England meetings that confirmed a continued bias to ease, and labour market data out of America that suggests QE3 isn’t about to end anytime soon.

This easing has created, and in some cases continues to create, significant downward pressure on G4 exchange rates.  We don’t accept the thesis of a currency war: central banks are responding to their mandates, although they are operating in an environment of little support from broader economic reforms.

The other side of the exchange rate story creates challenges for countries like New Zealand, where the exchange rate has gone from strength to strength, especially in trade weighted (TWI) terms.  However, while the firm exchange rate is making life challenging for New Zealand exporters, an environment in which G4 central banks hadn’t taken the unconventional and aggressive steps they have might have been far worse for the New Zealand economy.

The key question is what is the likely catalyst for a change in trend of the New Zealand dollar, especially given that the next move from the Reserve Bank is likely to be an increase in interest rates?  While there are domestic reasons why the New Zealand dollar should weaken, such as the current account deficit heading to 7% of GDP, the most likely catalyst for a weaker currency will a change in fortunes for the better in the G4 economies.

The new Japanese Prime Minister Shinzo Abe was elected with a mandate of enact a three-pronged assault on two decades of recession and deflation.   The three prongs are an increase in fiscal stimulus focussing on public works, structural reforms to boost productivity and aggressive monetary easing by the Bank of Japan (BoJ).

Enter Haruhiko Kuroda, the newly appointed Governor of the BoJ.  Following the adoption of a 2% inflation target, he has launched an aggressive deflation fighting offensive.  Measures in the package included expansion of the monetary base (cash and bank reserve) and a near doubling of monthly purchases of Japanese Government Bonds.  The Yen had weakened considerably since the more aggressive approach to monetary policy was first touted and fell further with the announcement following the April BoJ meeting.  The Yen has depreciated 24% against the US dollar since November last year.   We expect it will fall further as the easing proceeds.  

United States
The US launched QE3 in September last year.  It then changed its communication policy on interest rates from time specific guidance to the unemployment rate (6.5%) and inflation expectations (2.5%).  While the unemployment rate is inching closer to the Federal Open Market Committees (FOMCs) target of 6.5%, it’s not because of the sustained improvement in the labour market the FOMC was no doubt seeking when they set the target. Much of the gains in the unemployment rate have been due to the continued fall in the participation rate which as at March 2013 stood at 63.3, its lowest level since May 1979.  Meanwhile, inflation expectations remain well in check.

The FOMC has also continued to debate the relative costs and benefits of the continued asset purchase program.  Over recent months the release of FOMC minutes have at times spooked markets into thinking that QE might end sooner than expected.  Here’s the key point: both Ben Bernanke and Janet Yellen, (his likely successor) believe the benefits continue to outweigh the costs.

We believe QE3 will continue well into 2014 which will keep the USD weak.  The first step in its withdrawal would be a reduction in quantum of monthly purchases, which could be late this year, but will require a strengthening in job growth and further reductions in the unemployment rate.  The labour market challenge in the months ahead will be the amount of the automatic spending cuts that will be met by job cuts.

Euro zone
We credit the European Central Bank with much of the calm that has descended on the Euro zone and the reduced (though not eliminated) tail risks.  Its Long-Term Refinancing Operation (LTRO) program provided liquidity to a stressed banking sector and the more recent Outright Monetary Transactions (OMT) program, while still to be accessed, did much to reduce contagion fears.  However, while financial tensions in Europe are reduced, that is yet to translate into a recovery in output and jobs.

The Euro has depreciated significantly over the period of the debt crisis, but has appreciated more recently on the back of the reduction in financial tensions.  At the same time, some of the recent activity data has been softer than expected and expectations are that inflation will move lower.

Last week’s ECB meeting saw the central bank leave interest rate unchanged, but with a bias to ease.  Importantly the statement following the meeting dropped the comment from the previous statement about seeing signs of stabilisation and instead talked about the outlook being subject to downside risks.

That makes further interest rate reductions over the next few months likely, however we continue to believe that at such low levels, interest rate cuts would be largely symbolic.  That being the case they will probably look at further non-standard measures with ECB President Draghi commenting that the Bank is looking for ways to improve lending conditions to SMEs.

United Kingdom
The UK economy remains weak on the back of extreme fiscal consolidation and weak exports.  The March budget shows the Government remains committed to its fiscal consolidation path which as we’ve said many times has lost the balance between austerity and growth.

The Bank of England has previously cut its benchmark interest rate to 0.5% and launched a £375 billion asset purchase program.  The Bank has had its hands tied more recently as it awaits the arrival of its new Governor, Mark Carney, in July. 

The signals are his arrival will coincide with more easing from the BoE.  Mr Carney is on record as saying he doesn’t believe central banks have yet reached the limits of their capacity to support growth.  More important changes to Monetary Policy Committee remit mean the BoE will be able to interpret the 2% inflation target more flexibly and will most likely have access to a wider range of tools than they currently have at their disposal. 

Monetary policy in the world’s major economies will continue to be supportive of economic growth and reflation for some time yet.  The initial signals in Japan of more aggressive monetary policy settings led to accusations of a stepping up of currency wars.  We don’t agree.  Central banks are simply implementing the necessary monetary policy settings to meet their respective domestic mandates.

If we’re grumpy about anything it’s the lack of support given central banks from broader (supply-side) policy initiatives.  That has left monetary policy to do all the heavy lifting.  And no matter how much central banks ease, monetary policy can’t achieve necessary structural reform. 

Weak exchange rates in the countries easing monetary policy, particularly through asset purchases, are a consequence of those actions, not the intention.  The problem is it is making life challenging for countries on the other side of the exchange rate such as Australia, New Zealand and some emerging economies, where exporters are suffering under high exchange rates.

However, this outcome is the lesser of two evils.  The alternative would have been for the major central banks not to ease in the manner they have, but that would have left those countries in recession and possibly depression, which would have been a worse outcome for New Zealand exporters.

The New Zealand dollar is currently overvalued against four of the five currencies that make up our Trade Weighted Exchange Rate Index (TWI).  That’s against the US dollar, the Japanese Yen, the British Pound and the Euro.  We are at around fair value against the Australian dollar. 

Of course the strength of the New Zealand dollar is not just about weakness on the other side.  There are reasons for the New Zealand dollar to be strong including the still relatively high terms of trade, interest rates differentials and the general fact that we are just in better shape that most of the major developed world economies.

But when it comes to thinking about what is the likely catalyst to a sustained depreciation in the New Zealand dollar from its current over-valued level the most likely candidate is an end to G4 monetary easing, especially asset purchases.  That will most likely be some time away.  In the meantime we will see continued strength and most likely further strengthening in the New Zealand dollar.  This will continue to make life challenging for exporters and hampers the necessary rebalancing in the New Zealand economy.  It also makes life challenging for the Reserve Bank of New Zealand which is increasingly stuck between a rock (a strong exchange rate) and a hard place (continued absorption of spare capacity and a strong domestic housing market).  More on the challenge for the Reserve Bank next week.