Fed is ahead in the battle of the central banks

ALTHOUGH the US has shown signs of rebounding, a scratch beneath the surface reveals that there are still issues dragging on the world’s largest economy.

By historical standards, the pace of its current recovery is feeble. Research from Bank of America Merrill Lynch points out that the average annual growth rate of this recovery is 2.3 per cent, compared to 3 per cent after recessions in 1990-91 and 2001, and 4.5 per cent for the severe recessions of 1957-58, 1973-75 and 1981-82.

And there are reasons to be concerned. It was revealed yesterday that US consumer confidence fell to its lowest level in more than a year, due to the on-going fiscal debacle, and compounded by a 2 per cent hike in payroll taxes this month.

US politicians seem content to boot the country’s problems down the road: the debt ceiling was raised last week, and automatic spending cuts await in March, which will weigh on sentiment.

Now “a cloud of uncertainty hangs over the near term,” says Peter Newland of Barclays. It is this uncertainty that has shaken the US consumer. This is a concern, considering that consumer spending accounts for 70 per cent of US economic output. Friday’s consumer sentiment and spending data will confirm whether this reading is an aberration, or the start of a new trend.

In the meantime, today’s fourth-quarter GDP reading is effectively the acid test. Annualised GDP growth is expected to have slowed, from 3.1 per cent to around 1.5 per cent. However, this may not be dollar negative. Third-quarter GDP was largely driven by government spending, so the market will want to see improvements in private investment and net trade. If these are positive, the dollar may be able to shake off a poor GDP reading.

The dollar’s recent performance has been dictated by the fundamentals of other currencies, as exemplified by its movements against the yen and euro.

The euro’s recent upwards run against the buck is due to improving Eurozone sentiment, and the European Central Bank’s (ECB) shrinking balance sheet (as European banks begin repaying loans that the ECB poured into the market to help stabilise the sector). In contrast, the Fed’s balance sheet is expanding, passing the $3 trillion (£1.91 trillion) mark last week.

The size of Fed’s balance sheet is closely related to the value of the dollar (see chart). The Fed uses money created through easing to buy government bonds and mortgage securities. This creates heavy demand for these assets, pushing down yields; lower interest rates make the dollar less attractive. Traders then move money into higher-yielding currencies, and the dollar’s value falls. Further, this policy also has inflationary implications, which can drag on the currency.

Although minutes from the Fed’s previous meeting struck a hawkish tone (some member’s are concerned about the impact that aggressive easing is having on the financial system), a slowdown of this policy is unlikely. Indeed, the conclusion of the Fed’s policy meeting today is unlikely to bring a change of policy, since it was only six weeks ago that it expanded its asset purchases, and pledged to keep rates low for the foreseeable future.

Friday’s employment data has more market-moving potential. The consensus is for a reading around 157,500. A higher reading would, of course, result in a dollar rally, due to improving fundamentals that could result in a less dovish Fed in the medium-term.

But even if we get a positive reading, it would take months of sustained employment growth to reach a 6.5 per cent unemployment rate. As a result, the Fed’s relentless balance sheet expansion will continue, and will hit $4 trillion by the end of 2013.

Divyang Shah of IFR Markets says “this balance sheet divergence will support euro-dollar, which has a strong correlation with the relative balance sheets of the Fed and ECB”.

However, some believe that the euro’s recent run against the dollar will run into a wall. John Higgins of Capital Economics argues that, if the Eurozone crisis flares up – which he expects will happen in the second half of 2013 – demand for safe haven assets, like the dollar, will be back in vogue.

Against the yen, the greenback’s meteoric rise is due to Japan’s ultra-dovish stance in trying to engineer growth through inflation. Japan has now adopted a higher inflation target and is committed to further easing. If the rhetoric of Japanese officials is anything to go by, we can expect more yen weakness against the greenback.

However, Japan’s easing efforts will be in competition with those of the Fed. If Japan is unsuccessful in generating inflation, then markets may lose faith in its policy. Ironically, it is likely that this failure would drive the yen’s value higher against the dollar.

Even with Japan’s dovish advances, the pace that the Fed has grown its balance sheet means that it is ahead in the battle of the central banks. The ECB, it seems, is losing. But in the long term, ultra-loose policies are likely to make losers out of all central banks. What goes up, must come down. And balance sheets need to be unwound at some point.