The question must now be posed as to whether this weakening trend in the USD can be expected to extend much further. That is likely to depend on the prospects for quantitative easing by the US Federal Reserve. Undoubtedly much of the USD weakness since the Fed chairman’s speech at Jackson Hole on August 27 can be attributed to the markets pricing in this quantitative easing policy. In that speech the chairman clearly outlined his options to embark upon another program of quantitative easing following the first program which spanned from September 2008 to March 2010 over which period the Fed increased its balance sheet from $1.2 trillion to above $2.3 trillion. The bulk of outright asset purchases occurred between January 2009 and January 2010.
Markets were initially sceptical on how large any new easing program would be particularly given that there appeared to be considerable dissension within the FOMC. Over the last week the picture has, in our view, become much clearer.
Firstly, we saw a speech from acting vice chairman Dudley who is also the president of the New York Federal Reserve. The theme of the speech raised the bar with respect to the Fed’s urgency: ”My assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable”.
Next we saw a speech from Chicago District president Evans who has traditionally been seen to reflect the broad centre of gravity at the FOMC. He stated: "The size of the unemployment gap, combined with the fact that inflation has been running below the level I consider consistent with long term price stability suggests that it would be desirable to increase monetary policy accommodation to boost aggregate demand and achieve our dual mandate.”
On October 4, Dr Janet Yellen was confirmed as the new deputy chairwoman of the FOMC. Dr Yellen is known for her more pessimistic views on the health of the US economy and is seen as someone who readily supports the need for the Fed to take more decisive action.
On October 5, the Bank of Japan announced it would conduct "comprehensive monetary easing”; that is, a ¥5 trillion ($US60 billion) asset purchase program that will buy JGBs, CP, corporate bonds, ETFs and J-REITs. The asset purchase program is in addition to the passive lending program previously announced which is capped at ¥30 trillion. Our suspicion is that the asset purchase program target will be increased in ¥5 trillion increments as time goes by.
Other central banks such as the ECB and the Bank of England (we expect an increase in the asset purchase program in Q1 next year) are in the process of expanding their balance sheets.
These activities are in stark contrast with the Reserve Bank of Australia which, while surprising the markets that it did not hike rates on October 5, retains a strong tightening bias and, in our view, is likely to raise rates on November 2.
The speech by vice chairman Dudley was particularly important from our perspective. We had pencilled in a likely balance sheet expansion program from the Fed of around $US800 billion out to June next year. However Dudley’s speech has clearly raised the stakes. In the speech he assesses: "$US500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point.” The issue is where does the Fed believe the funds rate should be given its outlook for inflation and unemployment. The accepted way of assessing this is through the Taylor Rule models. Our estimates from various Taylor Rule models puts the desired Federal Funds rate at around minus 3 per cent .The guideline offered by president Evans is around minus 3.5 per cent. That estimate gives a higher weighting to the unemployment or output gap than to the inflation gap which is the accepted practise since Taylor first introduced his rule in 1993.
These calculations indicate that our original target of QE policy of around $US800 billion over six months is too conservative. A more likely target is around the $US1.5 trillion over a slightly longer period. We do not believe that such a policy has been fully priced into the USD and therefore expect considerable further weakness in the USD over the course of the coming months.
Of course a surprising recovery in the growth momentum of the US economy would temper the Fed’s policy in that direction. In that regard we are not optimistic. The absence of an appropriate fiscal stimulus package and the drag the ongoing deleveraging process will have on the US household sector are likely to ensure that growth over the 12 month period to June 2011 is likely to average around 0.8 per cent annualised – not sufficient to reduce the unemployment rate or raise inflation pressures. Such a profile for US growth would see the Fed maintaining its policy of balance sheet expansion – printing US dollars and thus weighing on USD exchange rates.
How much further might the US dollar fall?
The USD Index (the DXY measure of major floating currencies, so excluding managed currencies like China’s) has fallen from 88 in April to 77.5 currently. Its previous low points were around 71 in March to June 2008 and 74.8 in November 2009 (near the end of the previous QE episode, having fallen from around 88 near the beginning of QE). Speculation and the instigation of a new aggressive quantitative easing program could easily see the Index fall a further 5 per cent.
Over the course of the next nine months we expect the Reserve Bank will raise the overnight cash rate by 75 basis points. The Australian dollar will stand out as one of the few liquid, floating currencies where the central bank is not printing money – indeed it is tightening policy. The spectre of rising global risk which has always been the big drag on the AUD is unlikely to emerge while the major central banks in the advanced world are pumping up liquidity.
The other major risk event for the AUD would be a "hard landing” in China. It is true that the leading index for China is still pointing to on-going deceleration. However, we are confident that the Chinese authorities have the willingness and ability (very strong fiscal position and captive domestic excess savings; effective control of the credit channel) to ensure a soft landing.
Domestic issues would centre on global investors’ concerns about Australia’s housing market. It is our strong view that the structural shortfall of housing supply relative to demand, which is likely to increase over the course of 2011, will ensure house price stability in 2011, although we accept that prices are unlikely to be rising during that period.
Our view on commodity prices, which are likely to be supported by a surge in global liquidity and a soft landing in China, points to further strength and Australia continuing to report healthy trade surpluses over the course of 2011.
On today’s reading of around 98 US cents or so the AUD only needs to keep pace with a fall in the USD of around 4 per cent for it to register USD $1.02. That looks extremely likely over the next two months or so.
Furthermore, the likely continuation of liquidity policies by the major central banks is likely to support the AUD through to at least the middle of 2011. A target for the AUD during that period of $US1.05 seems reasonable.
Sometime in the second half of 2011 we are likely to see the quantitative easing policies curtailed. That should see a significant increase in demand for the USD. We also expect that the Australian economy will be losing some momentum around this time, which will see the Reserve Bank firmly on hold.
A move back to the 95-100 US cent range seems likely under such circumstances.
Bill Evans is Westpac's chief economist