The destiny of the dollar after QE3

The knee-jerk assumption is that this measure should be negative for the US dollar. That is generally true, but at the same time, history shows that the impact on currency markets of quantitative easing is ultimately limited. 

The Federal Reserve’s first quantitative easing programme (QE1) was announced in November 2008, with the main bond purchases occurring from January 2009 to March 2010. From November 2008 to December 2009, the dollar index, a weighted average of the dollar against other major currencies, weakened by 15 per cent. (The dollar also weakened by 6 per cent versus the baht.)

However, that move was very quickly reversed in the beginning of 2010, as worries emerged over debts in Europe. By June 2010, the dollar had recovered all of its losses. 

The second Federal Reserve quantitative easing programme (QE2) was first signalled in August 2010, and implemented from November 2010 to June 2011. 

The biggest impact on the dollar occurred from late August 2010 to early May 2011, when the dollar index weakened by 12 per cent (the dollar also weakened by 4 per cent against the baht). 

However, just like the first time around, that move was quickly reversed. The dollar was back to consistently strengthening from July 2011 onwards, as more bad news poured out of Greece, Italy and Spain. 

For QE3, the amount of purchases is lower than before ($40 billion per month, compared with a total of over $1,400 billion in purchases for QE1). However, the QE3 purchases are open-ended – the Fed is committed to the purchases until economic conditions improve. 

Expectations about QE3 were already growing before the Fed’s announcement – the dollar has weakened by over 5 per cent in the past eight weeks. The current bias is for the dollar to depreciate further. However, very prolonged and consistent dollar weakening appears unlikely – there are too many other factors at play, and quantitative easing programmes no longer have the power to shock markets. 

Now that uncertainty about the Fed’s monetary policy is past, markets will look to several other issues.

First is the story in Europe, where sentiment on the euro is an important counterpoint to the dollar. Are the promises of the European Central Bank and the establishment of the European Stability Mechanism (the new rescue fund) enough to reassure investors? Will Spain have to ask for aid? Are European banks sufficiently capitalised? What are the economic prospects – when will Europe move out of recession? 

Second is continued uncertainty in the US on the fiscal side. Are the politicians able to compromise on spending cuts? Will tax breaks and stimulus measures be available? Will there be a credible long-term plan to control public debt? An ability to at least partially resolve these issues and prevent gridlock after the elections could be a new driver for dollar strength. 

 

Parson Singha is chief markets strategist in the Global Markets Dept at HSBC Thailand.