Yesterday, when the Reserve Bank of New Zealand cut rates by 25 bps, something surprising happened. As we reported, instead of declining as it is supposed to do, the Kiwi soared to one year highs.
As we said, one explanation for this paradoxical reaction is that the rate cut had been too widely telegraphed (indeed, the OIS market had priced in a 100% probability of a 25 bps rate cut, and in fact there was a 20% probability of a 50 bps cut), which resulted in a massive short squeeze as disappointed shorts rushed to cover. We concluded by saying:
That is one explanation. The other, that central bank easing now leads to even greater FX strength, is simply too disturbing to consider.
Today both Bloomberg and the WSJ decided to look at the “other explanation”, and found something troubling, namely a “textbook failure“, both in the literal and figurative sense.
As Bloomberg puts it, “the traditional monetary-policy playbook calls for steps to weaken foreign-exchange values in order to spur domestic inflation and make a nation’s exports more competitive in global markets. Unprecedented stimulus policies from Europe to Asia this year have only sent currencies higher, frustrating efforts to spur economies.“
The WSJ echoes the sentiment, in an article titled “Textbook Failure: Why Rate Cuts Have Stopped Working on Currencies” in which it says that “It has been a year to forget for writers of economic textbooks. Rate cuts by global central banks have done little to weaken surging currencies. In theory, loosening monetary policy should lower a currency’s value. However, all this year the opposite has been happening.“
In addition to last night’s notable New Zealand example, where we also got the following stunning admission of failure by RBNZ governor Wheeler:
- WHEELER: IF WE CUT 50BP, MARKET WOULD STILL WANT MORE
… the WSJ also points out the prominent fiascoes in the past year, which all share a common theme.
It isn’t just the smaller economies in Asia: The Bank of Japan has had the same problem. A rate cut that took interest rates negative for some deposits at the start of the year has prompted a surge of yen buying and a 15.9% rally in the currency. And globally, the same phenomenon is occurring. Rate cuts in Indonesia, Russia, Hungary, South Korea and Taiwan in the past year have all done little to weaken surging currencies.
The common factor, fund managers say, is that interest rates are still positive in most of those countries, despite the rate cuts. That makes their debt more attractive for return-hungry investors faced with a growing pool of negative-yielding government bonds—$8.8 trillion, or just under one-third of all outstanding government bonds, according to J.P. Morgan. A negative yield means investors buying such securities and holding them to maturity can expect to receive less money than they put in.“
In an environment where a big part of the global bond markets are trading with negative yields, investors are rushing to find something positive,” said James Kwok, head of currency management at Amundi Asset Management.
There is one notable outlier: Japan “which has seen its currency strengthen even as yields on its government debt sink further below zero. Investors and analysts blame that oddity on everything from a growing perception that the country’s monetary policy is ineffective to the yen’s waning popularity as a funding currency.”
Whether the resulting currency strength is a function of central bank failure, or merely dollar weakness achieved following the famous Shanghai Accord, at which many speculate central banks agreed on a period of dollar weakness for the foreseeable future, it is unclear but it does point out something troubling: “Altogether, though, the textbook-defying currency moves have strengthened the view that when so many countries’ interest rates are stuck at similar levels around zero, it is harder than ever for central banks to manage the value of their currencies, said William De Vijlder, group chief economist at BNP Paribas.”
“The old textbook model isn’t dead, but its effectiveness has been weakened,” he said, citing the U.S. Federal Reserve as one central bank with the ability to meaningfully affect exchange rates.
Going back to the New Zealand example, traders quoted by the WSJ said they viewed the mixed messages as a tacit admission that the central bank’s efforts at depreciation are losing effectiveness, which sparked further buying of the New Zealand dollar. Reserve Bank of Australia Governor Glenn Stevens confronted a similar problem last week. Despite cutting rates twice this year, the Australian dollar is at the highest level in more than three months. Crucially, the currency is stronger than it was when the central bank started to cut rates.
To be sure, the indecisive Fed is also to blame: according to Kay Van-Petersen, Asia macro strategist at Saxo Bank, the U.S. central bank has been scaling back its expectations for how much it will raise interest rates this year. That tends to limit U.S. dollar appreciation and conversely, make it harder for other currencies to weaken against the greenback.
JPM agrees: “Unless the central bank gives some indication that the easing cycle could be extended or protracted over many months, markets tend to trade the end-of-cycle phenomenon,” John Normand, London-based head of foreign exchange, commodities and international rates research at JPMorgan, said in an interview with Bloomberg Television. “There’s no more downside to interest rates after this last cut and therefore the currency bounces.“
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Of course, there is a much more pragmatic answer, and one which Wheeler did stumble on last night when he said that no matter what he does “the market would still want more.” That is precisely what has happened with Australia, New Zealand, Japan and so on: the market still wants more. Much more.
In fact, the market wants central banks to go one step beyond and instead of just monetizing government and corporate bonds, it is now demanding that everyone join the BOJ and the SNB in buying up ETFs and single stocks, in the process sending the equity market to unprecedented levels. It is then, when central banks have bought up all the world’s stocks and bonds, and transferred all the wealth into the pockets of the 1%, that the confusion will finally end.
via http://ift.tt/2aOmYJS Tyler Durden