Hari Patti

Currency games

A big debate between investors, officials and financiers has been how much of the QE2 by the Fed is an attempt to devalue their currency. Some say that it is the primary (hidden) agenda of QE2. Others (and the Fed itself) believe it is a by-product of QE2 which is essentially aimed at spurring (domestic) economic growth.

One of the primary reasons why the dollar has been under pressure in the recent months has been the diversification of central banks (mostly in Asia) away from the USD. Historically these banks had been accumulating dollar reserves to anchor the appreciation of their own currency.

What is interesting is that if the Fed is really trying to devalue their currency by QE2, it doesn’t seem to be working. Ever since Bernanke’s Jackson Hole speech in August which was the first seemingly strong hint for a QE2, the dollar index, which tracks the USD against a basket of 6 leading currencies, fell more than 10% from its peak. Post the $600bn QE2 announcement, though, the dollar has rallied nearly 3%.

There is of course, Ireland and other Eurozone worries to a large extent to blame for that. But even then, I doubt the impact of QE2 being able to depreciate the dollar. The conventional wisdom of the dollar devaluing due to QE may not be applicable in this world…where if “I’m in bad shape, there are others who are in even worse shape.”

There could be other possibilities nevertheless. You buy the rumor and sell the fact. Markets overreact to rumors of QE2 and price in more than what is going to come, unknowingly.

If the European crisis were to worsen further, the dollar could gain more strength. This will only be amplified by emerging market countries putting restrictions on capital inflows. That may not do much to ease concerns in emerging markets. It does not mean that the dollar is going to experience a sustained rally; it may very well face weakness as the Fed continues its asset purchases for the next seven to eight months. Nevertheless, if domestic data continues to show improvement (nonfarm payrolls, consumer confidence Michigan index) the worst of the dollar slide may just be over.