Without question the school bully scored a resounding F-grade on his mid-term report card. So much so that the principal diagnosed a need for such deep remedial action that the school bully appeared to come out swaggering to the rest of the school about an A-grade. The fall of the dollar in response to the dramatic move was nothing short of spectacular. The unexpected expansion of the Fed’s balance sheet underscored the need for deeper measures to aid the economy. The reaction, however, was a positive one as investors reined in expectations as to precisely how long the economy would continue to wade through molasses.
The dollar liquidation was broad-sided. It appears that as much as the case for zero interest rates appealed to investors through an outward signal of pro-activity from a central bank, quantitative easing has an unwanted stigma attached that sours the palatability of holding onto associated currencies. As investors realize this they are quick to dash for the exits.
But that leaves something of a competitive devaluation underway. While the Bank of England was first to the game, likely knowing the unintended currency consequences of buying government and corporate debt, they likely saw this as a fly in the ointment. The British monetary authorities know all too well the perils of targeting or defending a currency. If quantitative easing is part of the cure, then let the exchange rate go. And of course the Swiss National Bank last week stepped up to shoot its first shot to defend its export manufacturers from too high a level for the Swiss franc. The Bank of Japan too has meddled with open market purchases and that leaves the yen lower too.
That leaves the ECB sitting on a couple of problematic issues. First, they refuse to buckle to calls to empty the monetary bucket despite a careening economic trajectory. Second, they appear less willing to engage in printing press policy, which is understandable only from the perspective that the members of the Eurozone spent a decade trying to squeeze into a fiscal corset. Some members today find themselves bursting out all over thanks to the severity of the downturn, which may threaten European harmony going forward. Finally, the ECB and moreover manufacturers now face weakening export markets thanks to a strengthening euro. The rise to $1.36 against the dollar is an effective tightening of European monetary policy, which arguably gives the ECB a fine excuse to lower policy, but a chance that we doubt they’ll jump at.
We don’t doubt that the Fed’s announcement that it will buy $300 billion of longer-term government debt and a further $750 billion of mortgage debt will continue to help the economy move from a downward path to a level one. The question remains as to whether the action spur a broader-based economic recovery. The financial system has been badly mauled and one wonders what desire banks have to return to the outright amount and type of lending practices that they did just a few years ago. Without a shadow of a doubt housing values have further to fall and that will weigh on spending and construction activity going forward.
Following Wednesday’s FOMC statement, investors watching the cascading dollar used the opportunity to buy around 14,000 put options on the Swiss franc on the Philadelphia Exchange. The theory looks good based on the action of the SNB last week who actively sold the Swiss franc against the euro and the dollar complaining about the impact its safe haven status was having. The trade appears to bank on the return of the SNB to hold down the value of the franc and we wait with baited breath to see whether they step to the fore in response to the Fed’s move.
With the Swiss franc today trading at Sfr1.1250 or one Swiss franc buys 88.95 U.S. cents, the Alpine unit is at a two-month high and off from $1.1968 when the SNB announced its steps to devalue the unit. Meanwhile the Swissy is a little firmer against the euro today at Sfr1.5370 from above Sfr1.5400 Wednesday. Option traders used next month’s expiring contract to acquire rights to sell Swiss francs (versus the dollar) at a fixed 84.00 strike price paying a premium of around 50 cents yesterday. The key now will be whether the SNB acts to defend Swiss strength independently against the dollar rather than the euro.