IB FX View

Bernanke’s cautious tone throws dollar lifeline

Tuesday July 21, 2009

Currency markets were caught on the hop overnight when an OpEd piece penned by Fed chairman, Ben Bernanke appeared just hours ahead of his semi-annual testimony to Congress on Capitol Hill. His bottom-line assessment that the U.S. economy is still nowhere near ready for a policy reversal flew in the face of equity market investors who have been busily discounting a return to growth. But an initial burst of dollar buying quickly ran its course as markets digested comments from Australian and Canadian central bankers where a growth surprise quickly led those currencies higher. In a twist of fate for CIT, recent headlines out of the company suggest bankruptcy fears have not yet passed, which is creating dollar and yen demand as equity prices abate.

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There has been growing speculation in the run-up to today’s Bernanke testimony that he might lay the groundwork for withdrawing that proverbial punchbowl in order to prevent excess at the Fed’s expense. In today’s WSJ article the fed chairman outlined five methods for mopping up excess liquidity in the event that the economy recovers.

When financial markets became crippled by illiquidity starting in 2007 many credit markets lost their way and banks refused to deal with one another in the event that someone might fail to repay loans. By stuffing these banks full of money the Fed was determined to tackle the crisis by strengthening banks’ balance sheets and at the same time making them so thoroughly liquid that they’d have to start lending, thus creating liquid and well-functioning markets at some point.

Mr. Bernanke’s comments aim to allay investors’ inflation fears. Many people assume that the Fed’s strategy is a resort to cranking up the money-printing presses and using a strict monetarist interpretation would result in too much money chasing too few goods. The result in that event would be rampant inflation. However, this is merely market myth. The Fed’s response has been to borrow money rather than print. As Mr. Bernanke outlines, there are ways and means of soaking up what might become excess liquidity and there are ways of rerouting bank deposits back to the Fed at whatever rate of interest the central bank determines. When unemployment and idle capacity are both rising, growth in the monetary aggregates is largely irrelevant. Efforts to reflate the economy could be likened to giving a balloon to a circus elephant in the hope it would blow it up. Only when recovery finally arrives might the ringmaster need to relieve the elephant of its tiring efforts and pump the balloon up on his own.

Mr. Bernanke says he believes that after an extended period of relaxed conditions he feels the Fed will be successful at normalizing monetary conditions while at the same time ensuring the Fed’s dual objectives of creating maximum employment and price stability.

While Mr. Bernanke is not exactly trying to talk down recovery hopes it’s probably true to state he’s being a realist. Yet in Canada today, while the Bank of Canada left its benchmark interest rate unchanged at 0.25% it seemed to give a subtle endorsement of a stronger currency. Noting the ill-effects of a rising Canadian dollar, it also noted that the recovery had been stronger than the Bank had expected and as a consequence the ligature on domestic activity was likely lessened. Stronger corporate earnings both domestically and in the United States coupled with rising crude oil prices helped lift Canadian unit to its highest reading in five weeks against the U.S. through 91 cents.

Minutes from the Reserve Bank of Australia helped set the tone for a strengthening of the local unit towards 82 U.S. cents in New York trading. The Bank noted at the time of the July 7 meeting that its existing monetary stance was resulting in sustainable growth. Chinese demand was surprisingly strong and provided a boost for exports while conditions domestically were proving far more resilient than were thought probable. Overall the Bank noted diminishing downside risks to growth prospects.

The British pound has lost some of its recent strength, but we’re not sure why. The news today is of the largest summertime public sector deficit since records began in 1993. Yet the 13 billion deficit is about what should be expected and hardly a market surprise. Perhaps it’s simply the case that the market is waking up to the impact of falling tax income at a time when fiscal spending is rising at a far greater pace. The pound today has fallen to $1.6466.

The Japanese yen is taking a leap forward versus the dollar after Mr. Bernanke’s delivery in Washington this morning. Currently the dollar buys 93.68 as the chairman lays it on thick that the time for tightening the reins remains a long way off.

Andrew Wilkinson

Senior Market Analyst ibanalyst@interactivebrokers.com

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