Anthony Harrington listens to currency managers’ frustrations as US dollar certainties melt into fog from the Fed

Before the Federal Open Market Committee (FOMC) meeting which concluded on 18 September, trading the US dollar against other currencies looked like it was shaping up to be a straightforward proposition. In May, the Fed had began talking up the likelihood of ‘tapering’ its quantitative easing programme occurring “soon” as part of its ‘forward guidance’ to the markets.

Those markets saw no reason not to trust chairman Ben Bernanke and the move seemed certain to result in dollar gains against a basket of other currencies. After all, the whole point of ‘forward guidance’ rests upon the premise that such guidance should be credible. A consensus opinion built up, predicting that the Fed would initiate tapering at the September FOMC press conference, and that the reduction in Fed purchases would be of the order of $10-15bn a month, probably evenly split between its mortgage securities buying and its bond-buying activities.

On top of the tapering expectations, in August the Syrian crisis took a dramatic twist with global condemnation of poison gas attacks and threats by US president Barack Obama to launch punitive cruise missile attacks on the Assad regime. Again, the expectation was that such geopolitical risk would trigger a flight to the US dollar.

Both of those theses were then spectacularly negated – at least for now. First, there was Bernanke’s surprise U-turn at his 18 September press conference, when he announced that data did not support tapering. Then the Russians took the heat out of the Syrian crisis by stating that president Assad was willing to hand over Syria’s chemical weapons stockpile to the UN for destruction. This proved enough to take the threat of an immediate military response off the table.

The coming crunch on the debt ceiling in the US may have been a factor playing on Bernanke’s mind, as might the fact that he is now effectively a ‘lame duck’ chairman, destined to bow out in January 2014. “Ben Bernanke has left the room,” is how PIMCO CIO Bill Gross put it after the 18 September briefing: the chairman was already adopting policy to the line held by deputy chairman Janet Yellen, who is now expected to take over in the new year with a considerably more dovish take, leaving rates loose for much longer. This would point to no tapering for some time and a steady slide in the dollar, unless inflation started to take off.

But the most likely reason for the U-turn was simply the way that markets reacted to the prospect of tapering.

Simon Derrick, chief currency strategist at BNY Mellon, says he remains a dollar bull, despite these ups and downs.

“We made the argument right at the start of the year that the dollar would recover, and the argument for this seems very straightforward,” he says. “When Bernanke began to suggest back in February that there might be a link between highly accommodative monetary policies and developing asset bubbles – something he had until then always strongly denied – that suggested to me that the Fed was thinking of more conservative policy settings going forward. And this was a good bullish hint. Then, in May, he stood up and said tapering was on the agenda and the markets reacted immediately.”

There is no doubt that the market reaction was intense. Emerging market currencies fell like a stone since tapering would have a dramatic impact on countries that had run up significant deficits borrowing cheap US dollars. The currencies of India, Indonesia, the Philippines and Malaysia in particular came under severe attack, forcing their central banks to draw significantly on the $7.5trn of US dollar reserves possessed by emerging markets.

“About 60% of the world’s portfolios are kept in US dollars and invested in US government securities, quasi securities and deposits,” says Derrick. “When you get a group of emerging market central banks wanting to support their own currencies by buying them back against dollars, they have to liquidate some of their dollar holdings. India’s reserves are down by some $17bn since April and Indonesia’s by $14bn. They are selling out of US securities to support their own currencies.”

Of themselves, these outflows from US securities have had an impact in forcing up longer-dated Treasury rates and this correlation between the EM crisis and Treasuries is a significant factor for the Fed to consider when it ponders the problem of how to go about tapering, Derrick argues. It also makes for more uncertainty in predicting dollar performance.

Some economists have argued that with emerging markets now contributing around 50% of global GDP, the Fed has to be wary of initiating policies which put those markets into crisis, since the impact on the US economy could be profound as such a crisis plays out. And some commentators IPE spoke with referred to rumours that a number of emerging market bankers went to Jackson Hole to plead their case with the Fed, pointing out how monetary tightening by the US would be hugely damaging to their economies. The Fed’s response, apparently, was to refer them politely and firmly to the IMF as the appropriate body to hear and respond to any economic or liquidity problems they might face.

 Indeed, Thomas Stolper, chief currency strategist at Goldman Sachs, points out that the Fed’s twin mandates are solely to focus on US unemployment and inflation. What happens in emerging markets is not the Fed’s business. Stolper notes that although EM currencies regained most of their losses within a day or two of Bernanke’s tapering climb-down, there is a very good chance that we will simply see a re-run of this crisis as soon as the Fed starts talking up tapering again.

The emerging countries most affected have been given a pretty sharp ‘heads-up’ message, but their structural problems will take time to fix and tapering could well be back on the agenda before the end of this year.

“The FX market is a relative value game, so we have to wait and see how things develop and to what extent the other central banks react,” says Ugo Lancioni, co-manager of Neuberger Berman’s Global Bonds fund. “This is not a currency war but markets experienced a significant tightening in reaction to the Fed’s guidance, and the impact was very hard on some EM currencies. In my view, the Fed is likely to watch global bond yields for a better timing to introduce tapering. What happens to currencies from here will be a function of other central banks reacting to the Fed continuing QE. They will not want to see their currencies appreciating sharply.”

Of course, as Lancioni’s comments on US tightening indicate, it wasn’t only emerging market currencies and bonds that felt the heat of tapering fever. He adds that his firm saw evidence of significant selling of global bond funds from the moment the Fed began to talk up tapering.

“Money poured out of US municipal bonds as investors saw the risk profile of this asset class rising as longer-dated yields rose,” notes Robert Tipp, chief strategist at Pramerica Fixed Income.

For him, the two factors combined made a case for backing away from tapering, although he was still surprised by Bernanke’s U-turn. “If you look at the US in a vacuum, as it were, what you see is probably enough positive growth to justify tapering,” he says.

US industrial production is now up 14% over the 2010 figures, inflation is very much under control and the US is further along the road to recovery than other developed nations. Longer-term, a move towards energy self sufficiency may lead to further shrinkage in the US current-account deficit over the next few years, draining the world of US dollar liquidity.

However, taking a global view – as those emerging market central bankers reportedly urged at Jackson Hole – Europe is just starting to get some traction and Japan still looks fragile.

“I think if the Fed was looking to gauge potential market reaction to the idea of tapering, what it found was rather too much fragility in the global economic landscape to start tightening,” Tipp suggests.

 “The problem with having high conviction views in the FX market currently, is that while central banks’ actions are not substantially inconsistent with developments on the macro economic front, at times the market interpretation of their guidance could lead to extreme price action,” says Lancioni. “They try to arrest or intervene when they feel market forces are not moving in their expected direction. However, the market is driven by supply and demand, and when investors dump out of one country’s securities and shift to another’s, the effect is significant, despite what central banks want.”

In other words, Bernanke’s problem with clear forward guidance is that if he even hints at tapering, he now knows that the markets will swing wildly in that direction, blurring the distinction he has tried to draw between tapering and an abrupt ending to QE. The one is tantamount to the other, in the market’s eyes.

This has blown ‘forward guidance’ out of the water, creating uncertainty over the central bank’s future actions. Not only was Bernanke vague on the question of quite what the data would have to be, sliding between 7% and 6.5% on unemployment, he also cast doubt on the idea that unemployment numbers were a good indication of quite when the data would be right for initiating tapering. The markets now have nothing certain to go on – and they probably also suspect that this is a deliberate Fed policy to stop them from over-reacting. It is also, of course, a policy that increases rather than diminishes uncertainty over what the ‘fair value’ might be for the dollar against other currencies.

It is all rather exhausting for the world’s currency managers. Jeppe Ladekarl, director of global macro at First Quadrant, goes so far as to say that Bernanke’s recent performance has been the first thing that has made him miss Alan Greenspan. “I was never fond of Greenspan,” he says, “but at least he could bullshit with panache. Bernanke seemed to cringe through that 18 September session.”

He finds it ironic that Bernanke’s solution to overreaction by the markets seems to have been to dive into Greenspan-like obscurity.

“There was that famous comment that Greenspan made,” Ladekarl recalls. “Something to the effect that ‘you might think you understand what I just said, but I really do know that you don’t!’”