INTERACTIVE INVESTOR : “Quantitative easing looms large over currencies”

Currencies Direct September 29th 2010 - 4 minute read

INTERACTIVE INVESTOR : “Quantitative easing looms large over currencies”

The prospect of further quantitative easing in the US and the UK has been weighing heavily on
both the dollar and sterling of late.

The recovery of the world’s largest economy showed signs of
running out of steam in the second quarter and forecasts for GDP next year are
currently being revised down.

The UK
recorded its fastest pace of growth for nine years in the second quarter although
recent data suggests this is not to last.

The markets have become unsettled as quantitative easing –
in both talk and practice – becomes increasingly commonplace. Analysts at
Commerzbank argue that it “no longer remains a tool reserved to fight a
systemic crisis”.

Market rumours now suggest that the Fed could start its
second round of asset purchasing by November.

Philip Ryan of
Currencies Direct said: “The weaker than expected level for US
consumer confidence in September published on Tuesday has only supported this
feeling as sentiment continues to be hit by job market concerns. Consequently,
the dollar remains under pressure, with little sign of stopping.”

So why more quantitative easing?

Quantitative easing works in a number of ways to help lift
GDP. It can lower borrowing costs by reducing the yields on government bonds,
boost asset prices and increase bank reserves to make lending easier.

It can also stabilise or raise inflation expectations.

Tim Drayson, an economist at Legal & General Investment
Management, said this is likely to be the justification for additional
quantitative easing in the US.

“The Fed might have to prove its anti-deflation
credibility with a further round of quantitative easing. The difficulty is
calibrating the amount. Too little could lead to a loss of confidence in the
Fed’s ability to stimulate growth. The Fed would then be forced to expand
quantitative easing on a massive scale in the next round to influence
expectations.”

However, analysts at Commerzbank added that fears are
mounting that quantitative easing could create future inflation risks which the
Fed will be unable to control. “The success of the measures will only
become obvious late. Until then, the risks dominate. And that means that until
then the prospect of quantitative easing 2.0 is putting pressure on the
dollar.”

The anti-dollar sentiment is currently benefiting the euro,
as investor confidence in the region grows.

The countries which were previously in the spotlight over
their public finances – Greece,
Italy, Portugal, and even Ireland – have received good demand
at their respective debt auctions, suggesting that confidence is recovering
from its record lows.

Simon Denham, chief executive of Capital Spreads, said:
“At some point we can probably expect a statement from an ECB member
sometime later this week or next stating that the eurozone is pondering more
rescue/stimulation packages in an attempt to reverse the recent Euro
strength!”

What’s going on with sterling?

Sterling
has also come under pressure as the Bank of England looks like it could extend
its £200 billion quantitative easing programme which finished in February.

The latest official figures show that underlying broad money
growth remains sluggish with the annual growth rate slowed from 2.3% to 1.9%.

Vicky Redwood, senior UK economist at Capital Economics
says: “Underlying broad money growth still looks very weak – supporting
Monetary Policy Committee (MPC) member Adam Posen’s view that more quantitative
easing will be required in order to boost money and credit growth and hence
support overall economic activity.”

Yesterday, Posen said the Bank of England should start
pumping more money into the economy to avoid copying Japan in the 1990s and falling into
a slump. He takes the view that UK
monetary policy should continue to be aggressive about promoting recovery and
that policy makers should not settle for weak growth out of misplaced fear of
inflation.

This all nods to the need for further quantitative easing.

Andrew Scott from currency specialists HiFX said:
“These are some of the most explicit comments we’ve had from any member of
the Bank’s committee in favour of the Central Bank providing additional
stimulus. This may come as a surprise to some, as the economy is still growing.

“We are still some way from this view being shared
amongst a majority of MPC members, which would be needed for the easing to be
approved. Nevertheless, after last week’s central bank comments, traders are
very focused on quantitative easing, whether here in the UK or in the
States”.

Posen’s views may have been tempered by the hawkish Andrew
Sentance who has repeatedly called for interest rates to rise from their record
lows and says no further quantitative easing is needed but the pound still
dropped sharply after his comments.

Duncan Higgins, senior analyst at Caxton FX, commented:
“Quantitative easing is not a phrase that traditionally sits well with the
pound and with the door very much open to the possibility; sterling may
struggle to regain its poise in the short term.”

Capital Spreads said that, although “Cable is being pushed
around by comment, the supports at $1.5770 and $1.5725 look solid for the
moment”.

Over the longer term, Higgins said that sterling should get
some support from eurozone troubles, with Spain’s
credit rating expected to be downgraded and Ireland’s Anglo Irish bank in hot
water once again. “We still expect to see sterling to trade comfortably
above EUR1.20 before year-ends.”

Currencies Direct’s Ryan added: “Sterling/dollar is
likely be whipsawed as the debate continues and is set to lose additional ground
against the euro.”

Written by
Currencies Direct

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