What a month it has been for monetary policy! Central banks around the world have gone pedal to the metal on monetary easing and are moving as fast as they can to jumpstart their economies. With the Bank of Japan joining the European Central Bank and the Federal Reserve in cranking up their asset purchase program, we now have three major central banks flooding the markets with liquidity, putting the race to debase or devalue their currencies in full gear. Traditionally, monetary easing is negative for a country's currency, but with all three central banks moving at the same time, investors are wondering which currency will be the biggest loser.
To answer this question, we first compare the announcements made by the three central banks. Both the Fed and the ECB have unveiled unlimited asset purchase programs, and while the ECB has the benefit of being the first to market, their program cannot start until a country formally requests for aid. So far, Spain -- the Eurozone's primary problem -- has shown little desire to ask the ECB for more help. In countries like Spain, many people believe that making a deal with the EU/IMF/ECB is akin to making a deal with the devil due to tougher austerity measures. In their ideal scenario, they would like to put off a sovereign bailout for as long as possible in hopes that in the end, they won't need it.
On the other hands, the Federal Reserve expanded their asset purchase program immediately. So even though both central banks pledged to buy more bonds, the Fed is the only one of the two that has put money on the table -- which is exactly why in the long run, we expect the dollar to underperform the euro.
The greenback should also end up losing the race against the Japanese yen because the Bank of Japan's expansion was limited to Y10 trillion. This was an amount that most economists anticipated, albeit in October and not September. The main difference between the Fed and the BoJ is that the Fed surprised in terms of timing and magnitude. The U.S. central bank pulled out all of the stops and sent a strong message to the market by going above and beyond expectations. The Bank of Japan, on the other hand, simply sped up their timetable for monetary easing. Also, the BoJ has been far less effective than the Fed when it comes to influencing its exchange rate, even though their past actions have successfully boosted stock prices and lowered bond yields. While we believe there is more downside pressure on the dollar than the yen, USD/JPY weakness should also be limited to the 75.50-76 range because below 77, the risk of Japanese intervention increases significantly.
In the race to debase, we expect the U.S. dollar to be the biggest loser, but that may not happen immediately. As we have seen after QE1 and QE2, it could take some time for the greenback to finally lose value. In the meantime, the concurrent easing by the Fed, ECB and the BoJ should reduce volatility in the FX market, which could lead to tighter ranges for major currencies. If the stability fuels further gains in equities, a risk on rally could also drive the dollar lower.