|
|
The contrast in approach to central
banking between the U.S. Federal Reserve (Fed) and the European Central Bank
(ECB) is remarkable. ECB President Draghi has done more
to lift market concerns with a targeted strategy than Bernanke’s blunt
attempts. In announcing the Outright Monetary Transactions (OMT) program, Draghi not only shored up market concerns, but also
forced upon European policy makers a pathway for a fiscal framework and
centralized fiscal oversight. From a currency perspective, such steps may
serve to bolster the euro. In contrast, Bernanke appears willing to do all
the heavy lifting on the economy while gridlock remains in Washington. We
fear that the unintended consequences of such accommodative policies may
undermine the U.S. dollar over the foreseeable future, and ultimately pose
significant risks to the U.S. economy.
The conditionality of the ECB’s OMT program
announced in September is an important step, as it effectively takes away
sovereignty over a participating country’s fiscal decision-making
process. The program, in which the ECB may engage in unlimited, but sterilized,
purchases of short-term government bonds of Eurozone countries, is
conditional on governments applying for help and ceding sovereign control
over their budgets. It also forces Euro-area politicians to agree upon fiscal
limits and targets, as well as the oversight and implementation of such
measures. Importantly, it is not up to the ECB to determine whether the
governments receiving help are abiding by the rules imposed on them,
maintaining the ECB’s independence. We believe the OMT program encourages
the Eurozone to move closer to a currency union with a defined process on how
to address fiscal challenges.
Ultimately, for the ECB to act effectively as an
independent central bank, and for the euro to act as any other free-floating
currency, European politicians need to act as a fiscal union. The
establishment of centralized fiscal oversight is thus a necessary
precondition for the long-term sustainability of the monetary union. At the
same time, by explicitly stating its intention to stand behind European
countries as a backstop and do “whatever it takes” to ensure the
viability of the euro, the ECB has taken some of the tail risk, or
“black swan” risk, out of markets. Improvements in Target 2
balances within the region are clear in the following chart:
Despite recent improvements, we foresee ongoing
market volatility. We have argued for a very long time that Europe’s
problems will not be fixed overnight, but rather, are likely to be a
long-drawn out, somewhat dysfunctional, process. Politicians are not
incentivized to act until the bond market forces them to act. We currently
see this dynamic playing out in Spain: as soon as market pressure abates
– i.e., interest rates fall to more manageable levels –
politicians become reticent to ask for help; after all, in asking for help
they must give up control over the country’s fiscal decisions.
Unfortunately, for this very reason, we believe volatility is a necessary
prerequisite for progress to be made in Europe; it is only when interest
rates are at unsustainable levels that politicians are forced to act. That
said, it may be a long, messy process but giant steps have now been put in
place towards centralized fiscal oversight of the Eurozone. From a currency
perspective, we view these steps positively for the euro.
Another important development in Europe are the talks surrounding centralized oversight of the
banking industry. We believe the ECB is correct to push for implementation of
a single supervisory mechanism for Euro-area banks. Such a mechanism is
important in lessening the disparity among Euro-area nation financial
industries and may help to reduce future crises. It is simply unsustainable
for each member country to oversee its respective banking industry as it
inherently increases geographical contagion risks, exacerbating downside
economic pressures.
The existence of a centralized banking oversight
mechanism may help lessen the probability of runs on the banking industry of
select countries. For instance, banks domiciled in weak periphery nations
have been the target of short selling and depositor withdrawals, largely
because those same banks have significant exposure to the downgraded
sovereign debt of the countries in which they are domiciled. Greek banks held
a significant proportion of Greek government debt on their balance sheets.
Likewise, Spanish banks have significant exposure to Spanish government debt.
The same is true for Italian or Portuguese banks. Aside from lack of
consistency and uniformity, a key problem with individual country banking
regulation is that each respective regulator deems local sovereign debt
“risk free”, thereby incentivizing the local banking industry to
be overexposed to that same sovereign debt. Having a centralized banking
oversight mechanism may help alleviate these concerns. The process towards
centralized oversight is unlikely to be a quick or smooth one, as there are
so many vested interests, but positive steps appear to be being made.
It is important to note that despite all the
concerns surrounding Europe, the euro is not trading at parity to the U.S.
dollar. In fact, the euro has held its value relatively well. We believe one
of the reasons for this is the fact that the Eurozone as a whole has a
broadly balanced current account. In contrast, the U.S. has a massive current
account deficit, meaning the U.S. is reliant on investment from abroad simply
to stop the dollar from falling. As a result, the U.S. is required to
generate economic growth to attract capital from abroad. The euro
doesn’t have this same pressure.
In addition, the ECB has been more refrained in
implementing accommodative policies relative to the Fed. The ECB has the
single mandate of ensuring price stability as opposed to the Fed’s dual
mandate of fostering price stability and maximum employment, the latter of
which is its justification for extensive and ongoing monetary easing. Like
any asset, when there is an increase in supply with no offsetting increase in
demand, this naturally creates downward pressures on price. We believe such
dynamics are playing out in the U.S., especially on the back of QE3, and are
less evident in Europe. While concerns remain over the future direction of
Europe, we consider that U.S. monetary policies are more detrimental to the
value of the U.S. dollar. As a result, we believe the euro may appreciate
relative to the U.S. dollar going forward.
In our opinion, the ECB has done a good job in
maintaining its independence, while not encroaching on fiscal policy, but
rather forcing upon policy makers a process by which they can make steps
towards fiscal co-ordination. In contrast, the U.S. Fed has once again
encroached on fiscal territory in setting monetary policy. By announcing QE3
and its open-ended, unlimited purchases of mortgage-backed securities (MBS),
the Fed is specifically favoring one portion of the economy over others: the
housing sector. It’s not hard to see why. We believe Bernanke wants to
instigate home price inflation and, in so doing, bail out the millions still
underwater in their mortgages. Gridlock in Washington has meant Bernanke has
taken it upon himself to address the issue. The problem is,
funneling funds to certain sectors of the economy has traditionally been the
realm of fiscal policy, NOT monetary policy. We saw what happened in the
aftermath of the first round of MBS purchases: Bernanke was hauled in front
of Congress and the House on numerous occasions to explain his actions. Such
political pressure only serves to undermine the independence of the Fed;
empirical evidence supports the notion that the more independent a central
bank is, the greater the likelihood of price stable environments.
QE3 appears to have been effective in raising
inflationary concerns. Indeed, market implied measures of inflation increased
significantly in reaction to the announcement. Our concern is Bernanke and
the Fed will now err on the side of inflation in attempting to drive the
unemployment rate lower. The September Federal Open Market Committee (FOMC)
minutes make it clear that the Fed would like to introduce a numerical target
for the unemployment rate, looking to move away from a focus on moderating
inflation and placing a greater emphasis on trying to improve the employment
situation. This change in focus is worrying, as it further severs the link
between monetary policy and inflation.
Moreover, through manipulation of the yield curve,
the Fed is inherently increasing the risk that it gets monetary policy wrong.
Every time the Fed purchases Treasuries or MBS, it drives the yields on those
same securities lower. In so doing, the Fed can no longer rely on those
yields to provide valuable information on the state of the economy, as the
yields no longer reflect free market forces. As such, through its
accommodative monetary policies, the Fed has taken away a key gauge in
estimating and setting appropriate monetary policy. Put simply, the more the
Fed manipulates markets, the greater the chance of unintended consequences,
such as inflation and further deterioration in the U.S. dollar.
With such dynamics playing out, we believe investors
may wish to consider adding a currency component to their portfolios, to
potentially benefit from an ongoing decline in the U.S. dollar. A
professionally managed basket of currencies may help to protect against
inflationary pressures, while providing valuable portfolio diversification
benefits and upside potential.
|
|
