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We have a question here from Gabriel asking how something like quantitative easing usually impacts currency prices in both the short-term, as well as the long-terms, thanks for the question.
Now, the short answer for this Gabriel is that QE usually shoot from a theoretical point of view, have a negative impact on the currency in both the short-term, as well as the long-term, and the reasons for those comes down to basic supply and demand dynamics.
So when a central bank performs quantitative easing, they’re essentially pumping money into the system, right? So from a supply point of view, it means over supply versus demand, and that should see the value for. But the dynamics of why it’s negative for the currency at that point, also comes down to interest rates itself. So QE is considered as an unconventional monetary policy tool and is only deployed when lowering interest rates at the short-term on the short-term interest rates, doesn’t have the desired effect in the economy. So with the type of economic downturns we saw during the global financial crisis, and now during COVID-19, we’ve seen that lowering interest rates itself to stimulate growth in the economy, wasn’t enough. Central banks had to do more to boost confidence in their economies. Now usually lowering interest rates, makes cash cheaper, right? It lowers borrowing costs for individuals as well as companies which means credit is a lot cheaper and that normally incentivizes people and companies to buy lots of stuff they really want, but can’t afford with money they borrow at lower rates from the banks.
Now, during these last two financial crashes we’ve had, lowering rates wasn’t enough to do that. So the banks had to do more to stimulate the economy, to bold confidence by performing something like quantitative easing.
So it’s not only from a money supply point of view, but it also creates confidence. And what they do, is they basically pump the market full of money, and remember that it’s already cheaper money, due to interest rates already being lower.
Now, of course, there’s other benefits to something like quantitative easing, such as keeping the back end of your curve, flatter or lower, basically keeping longer term interest rates lower for longer as well. And the reason why they wanna do that for example, is again, to try and instill confidence in what they’re trying to do.
So they’ll already keeping interest rates low by keeping the actual interest rate itself, low or close to the zero-bound level. And then they’re also performing quantitative easing to try and to keep those longer term interest rates lower for longer to try and give confidence for markets.
So they’re basically telling companies and individuals, don’t worry rates are gonna stay low for a very long time. So it gives companies a time to plan, they will make bigger investments, borrowing money, et cetera, because they know longer term rates are also gonna keep and stay longer, stay lower for longer. And that’s also where something like yield curve control comes in. Where they can try and target specific maturities to see if they see any weird imbalances in terms of the yield curve, they can try target specific maturities to try and keep those rates in balance.
Now the opposite of quantitative easing, is of course called quantitative tightening sometimes also called tapering. And that normally has the opposite effect again, on the currency creating demand for the currency creating or increasing the value of the currency. But like anything in markets, you know, it’s moved it’s by expectations and not normally by the act itself.
So for example, the anticipation or expectation that a central bank will perform quantitative easing or tapering will often already be enough to seeing the currency lower or higher in the short-term. But the most important thing to take away is that, you know, in markets, it’s never just one thing. It’s not just QE or just tapering, there’s always a range of factors that we need to keep track of because even though currency should weaken on QE and strengthen on QT or tapering, it doesn’t always happen that way. And let’s take a look at a few examples here.
So on this chart, we have the U S 10-year yield and we also have the U S dollar and we’ll look at a few of the reactions from the Feds previous QE programs. So QE1 was announced back in November, 2008, that sort of desired reaction. We had downside of the dollar, we had downside in yields same when it was actually expanded a couple of months later, downside in yields, downside in the dollar.
Fast forward to 2010, we actually had QE1 terminated, right? So they, they stopped buying and that would normally see upside in yields, as well as the U S dollar.
Now we did see upside on the dollar, but we saw the opposite reaction in yields. And the reason for that is very important, at that same stage we had the sovereign debt crisis popping up in Europe. So the reason why bond yields went down and the reason why is the same reason why bond prices at that time went up, is because equities actually lost 11% in quarter two of 2010 due to the fears about the sovereign debt crisis.
So markets were in a flat spin and the reaction we saw in bonds and the dollar was basically a flight to safety, which increased the value of bonds and increased the value of the dollar despite the fact that QE1 stopped. Right now we had QE2 was hinted back in August, 2010, that had the desired reaction, right? So it hadn’t started at that time, it was just hinted that it might be a possibility, it gave the desired reaction, and when it was actually announced, it had the opposite reaction.
So a little bit of a possible by the room and sell the fact reaction there, but the market at that stage had already recovered as well, and the dollar was moving up because Europe was basically suffering on the back of the sovereign debt crisis, so opposite reaction there from what you would expect. Then we had the operation twist where they bought longer maturities and sold shorter ones to try and stop the back end of the curve moving higher. A lot of sideways price action there for the most part, nothing too major to watch. Operation twist ended also more muted reaction there. QE3 was announced, limited reaction there. We did see some upside but rates or yields fully remained flat there, so not really seeing the reaction that you would expect. Twists was terminated in December 12, QE3 started and that had a little bit of a muted reaction at first, and then you saw the dollar going up and yields going lower. Looking at the first tapering expectations, those were important. Going back to 2013, if you ever hear the term taper tantrum, that’s when the market’s had a little bit of a taper tantrum, where you saw yields in terms of the 10-year shoot up to the upside where the market started to expect that the FMC might start to taper that bond buying program.
That’s our major move higher in yields, obviously in interest rates and obviously saw lots of downside in bonds, the dollar also reacted, not as anyone would expect in that reaction. The reason for that was at that time, we started to see lots of recovery in the rest of the world compared to the U S dollar, especially in Europe. And that’s a lot of downside in the dollar index because other currencies like the euro and the pound starting to outperform the dollar, in that stage.
Now we actually had tapering beginning, that saw upside additional upside as you would expect, from something like the U S 10-year. The dollar moved a little bit more flat, and now it gets a little bit more interesting.
So coming to the end or the third quarter of 2014 year, we started to see the Fed starting to prepare the markets for the balancing plan. So even though tapering had begun, they started to ease in the ideas that guys eventually will need to start raising interest rates again. And that’s all lots of upside for the U S dollar, and the reason why yields actually came down here was the fact that equities came down as the market started to realize that the gravy trend will eventually need to end. And that’s all lots of downside and something like bond yields as flight to safety, as you know, exiting from equities, moving into bonds.
So the opposite reaction in yields, but the dollar of course outperformed, as the market started to anticipate higher rates for the U S but also again, the ECB launching a bazooka was there whatever the QE program as well as great debt issues started to see lower, currency values for the euro and the pound, et cetera. And that, of course saw the dollar out perform again.
Now, if we fast forward to the more recent moves we’ve seen, you know, the QE, the massive amount of QE we’ve seen from the Fed as at the expected result in something like the U S dollar with the U S dollar moving lower, but at the same time, the expanded QE program for the ECP is at the opposite effect on the euro. Because the focus for the QE on the QE side for the euro right now, isn’t on the theoretical effects that it will have on the money supply, but it’s all about confidence.
So the fact that the ECB is taking out a bazooka and member states are putting together to find ways of having joint debt issuance, raising capital with that recovery fund, et cetera, that’s showing strong signs of unity. And that has really boosted confidence in the euro rather than weakness from a QE point of view.
You know, the ECB has also been buying data from struggling countries under the pay program. Basically places such as Italy, they’re not buying proportionately on the Italian side, they’re buying disproportionately because the aim of the program is trying to help out, in those specific countries that are struggling.
So the point I’m trying to make here is that yes QE is normally a negative in the short-term and the long-term for currency, but it’s not always a negative depending on what else is going on in the global macro markets.
That’s why we always need to be in tune with the global macro themes, that’s driving the markets at any given moment. Also remember that again, expectations drive the market. So when markets anticipate QE or anticipate tapering, that can already be enough to start moving the currency up or down, depending on what the expectations are. So when you see things like daily market operations, where a central bank buys bonds, but it’s part of the, you know, ongoing or currently announced QE your program like, part of your question for the IBM Z’s announcement earlier today, that type of thing isn’t really gonna move the market because it’s all new so to speak.
We already know they’re in a bond buying program, so they’re basically just buying the monthly or the daily amount or the weekly amount that they say they’re gonna buy.
When those type of daily operations will get the market’s attention is when they suddenly stop buying for a month or two, and they don’t tell us why, or they suddenly buy two or three or four or five times their regular amount, and they don’t tell us why.
Those types of things will start to get the market’s thinking. And, but as far as regular day operations are concerned, it’s not really gonna be a big daily mover.
So I hope that gives you a little bit of background on QE and how it’s expected to move currencies. And of course, giving you some caveats on some possible times when it might not have the theoretical effect that you expect it to have on currencies.