Balance Sheet Fluctuations Have Replaced the Cash Rate

Following on from the previous note on Fed tapering and the new realities of monetary policy, I wanted to show graphically how correlations have changed and how this should affect asset prices moving forward.

I’m looking at EUR/USD here as the relationship is so clear, but equally revealing is a look at Federal Reserve assets against SP500 performance. Everyone already knows that Fed purchases have a direct relationship to equities performance, and I’ll talk about this in the next post. On the other hand, some people are confused that the Euro has not fallen to parity, so this is more interesting to talk about in the context of balance sheets and to show how rate policy has been replaced.

Prior to ZIRP there was little positive correlation between the balance sheets of the two central banks and the nominal exchange rate. More important were interest rate differentials, trade policy, relative economic performance and so on. Asset purchases were not the explicit form of monetary policy and so traders did not give such a heavy weighting to this balance. Of the previous determinants of exchange rates, interest rates have always been one of the most important, but more specifically expectations of policy easing vs. tightening.

Zero Interest Rate Policy was reached at the start of 2009, with the Fed Funds rate effectively zero. This means traders have needed to look to other forms of policy change for direction, and the most clear is asset purchases. The ECB’s policy rate has been in the region of 1.50-.25 percent since the onset of the crisis, it’s fluctuations were still able to have an effect on valuations, but not as strongly as the promise of balance sheet expansion (and in the case of the ECB – balance sheet reduction). Lets zoom in on the relationship since ZIRP was introduced:

This has made it very simple to understand where the respective currencies are heading. In the last month the ECB has taken steps to stamp out Euro appreciation by cutting rates to 0.25% and verbally discussing asset purchase programs. Leading up to this however the Fed has been vigorously outpacing ECB purchases with its 85 Billion-per-month program while European banks paid back LTRO loans (shrinking the ECB balance sheet). This has resulted in strong performance of the Euro, confusing Euro bears. The last rate cut goes some way to offsetting US easing, but until the ECB finds a way to adopt it’s own QE or further LTRO it will be plagued by a strong Euro while the Fed maintains QE.

The implications of this is that now that ZIRP has made rate policy defunct (and Central Banks are unlikely to raise rates), the market will be judging the banks’ easing bias by its expansion and contraction of balance sheets. The Fed is unlikely to contract it’s balance sheet, and statements have implied the securities will be held to maturity – therefore it is more likely that the end of expansion will be the equivalent of Fed tightening rather than an actual reduction in balance sheets. Traders don’t have another policy move to watch at the moment, and so focus is ever more focused on the timing and rate of a QE tapering.

As a side note however, there are also other reasons that Euro bears should not be bearish on the currency. If we ignore for the moment that German bureaucrats heavily resist most monetary easing (and so ECB policy has been much tighter than it could be), it should be understood that if the Euro is to collapse, this would probably be supportive of a stronger Euro.

Analyzing who has benefited the most from the Euro, Germany is the main benefactor – its trade policy keeping wage growth suppressed relative to productivity and the EUR being undervalued relative to a German national currency such as the Deutschmark has resulted in low unemployment and stable growth at the expense of peripheral European countries becoming heavily indebted. Germany is probably the least likely to leave the Euro because of it’s competitiveness benefits and the fact that it has a lot at stake in the project in loans to peripheral countries etc.

The peripheral countries however, while perhaps not a certainty to leave the Euro are surely more likely to than Germany. The PIIGS have been adjusting to this trade imbalance through rising unemployment and economic misery for now, but it can’t be ruled out that one or more of these countries comes to the conclusion that it will be less painful to regain competitiveness by leaving the Euro and devaluing a sovereign currency. If such a thing were to happen rather than the implementation of a fiscal union, the Euro should strengthen as the effect of weaker economies is removed from pricing in the Euro.