In “Yielding a pattern” (below), box 1 shows the outbreak of the 2007-8 financial crisis. Equity indexes fell alongside bond yields, with the dollar benefiting as deep deleveraging and sharp market losses eroded global growth and reduced inflation. Money exited commodities and higher yielding instruments, and sought refuge in the U.S. dollar, primarily in the form of U.S. Treasuries. Once global central banks stepped up their liquidity operations in Q1 2009 (box 2) to stabilize financial markets and help banks via quantitative easing from the Federal Reserve and Bank of England, stocks rallied by more than 50%, causing a rebound in bond yields due to improved global economic conditions and the threat of inflation. This pushed money away from the USD-denominated cash and into higher growth commodities, their faster-moving currencies and emerging market equities.
Once the Fed’s quantitative easing expired in January 2010, the stimulus ran out of the markets and equity indexes began to suffer at the benefit of the U.S. dollar (box 3). These moves were especially exacerbated by tensions in the Eurozone (Greece, Portugal and Ireland credit rating downgrades). The U.S. dollar also was supported by improved economic data, while global bond yields fell in tandem on renewed worries of economic growth — this time on fears from the then-nascent Eurozone debt crisis. This explains why box 3 is largely similar to box 1.
In autumn 2010, as markets licked their wounds from the onslaught of credit rating downgrades in the Eurozone and the May flash crash, the U.S. Fed went for additional stimulus via the announcement of QE2 in November (box 4). The anticipation of the announcement had built up earlier that summer, triggering a fresh run-up in U.S. and international equities. Note the similarity between boxes 4 and 2.
The cycle continued when the Fed’s QE2 ended in June 2011 and raised questions about the need for QE3. Markets were not pleased with the eventual announcement of Operation Twist, which involved replacing short-term interest rate purchases with longer-term Treasury purchases but no net additional buying, hence no extra liquidity as was the case in outright purchases in QE1 and QE2. This is seen in box 5 via the decline in yields and the sell-off in equities suffering from escalating risks in the Eurozone, evidence of a slowdown in China and the rest of the BRICs (Brazil, Russia and India).
The run-up in global equities between January and mid-February resulted from an infusion of central bank liquidity (ECB offered nearly €400 billion in three-year money at 1.0%, the Fed said it would extend its zero interest rate policy through 2014 from previously stated mid-2013 and the Bank of England entered QE3 with an additional £50 billion in fresh asset purchases).
Going forward, we view the Fed unlikely to continue shoring up confidence by simply restating that rates will remain “exceptionally low” until 2014. Once the recent U.S. data improvement cools off (because of mixed performance in BRICS, the impact of high USD on U.S. equities and Eurozone sluggishness), demands for U.S. QE3 likely will escalate via a sell off in equities, as was the case in spring 2010 (box 3) and summer 2011 (box 5). This would translate into falling bond yields, and a rising USD.
USD bulls, however, must be warned of an uninterrupted expansion in Asia, more specifically China, which likely will maintain the buying-the-dips in the Aussie and Canadian dollar via robust commodities. Thus, to avoid this risk, USD longs are more viable against the euro and the Swiss franc.
Ashraf Laidi is Chief Global Strategist at FX Solutions/City Index, founder of AshrafLaidi.com and author of “Currency Trading & Intermarket Analysis.”