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This post will discuss the self-induced austerity measures U.S. politicians have manufactured, a major hurdle to the recovery in the world’s largest economy.

The U.S. economy is headed in the right direction thanks to stronger consumer confidence, and now the Federal Reserve is signaling that its policymakers feel that it may be soon to begin the process of draining liquidity from the financial system. But this could not come at a worse time. U.S. politicians remain dramatically partisan and refuse to cooperate on nearly anything; voting among party lines for every major vote in recent memory, seemingly if only to spite one another.

 

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The best manifestation of this division is best exemplified by the budget negotiations, which have pitted Democrats, in control of the White House and the upper legislative house (the Senate), against the Republicans, in control of the House of Representatives (the lower legislative house). The first such impacts of these cuts were seen in the 4Q’12, when the U.S. economy contracted by -0.1% annually. Why?

The swift -22.0% annualized cut in defense spending, the sharpest pace in a decade, alongside weak inventory growth and the trade deficit (when imports outpace exports), created a -2.7% annualized drag on the U.S. economy. This drag was just enough to offset the strong combined +2.6% annualized growth rate in consumption and private investment (further highlighting how much stronger the U.S. consumer is). This weak growth is noted on the graph above on the far right, where the 4Q’12 GDP figure is circled, with the notation “austerity,” the term meaning “a fiscal policy that entails reduced government spending and higher tax rates, with the purpose of eliminating a budget deficit.” Clearly, a further reduction in government spending – part of that -2.7% drag, best reflected by the steep drop in defense spending – is going to weigh on growth.

As the headlines surrounding the budget sequestration, as it is officially called, continue to flow. In total, $109B in cuts will be made over the course of 2013; however, this results in $85B in cuts on March 1 alone. This will be the beginning of $1.2T (T for trillion) in budget cuts from 2013 through 2021, unless new measures can be agreed upon.

If politicians do not address the budget sequestration right away, then any prolonged period of drain on the economy could negatively affect the U.S. Dollar. While any increased credit risk is likely to roil global markets just as it did in 2011, culminating in Standard & Poor’s downgrading the United States’ then-pristine rating from ‘AAA’ to ‘AA+,’ the weaker economy could alter the Federal Reserve’s exit plans. If it becomes clear that the Fed will have to reverse its recent rhetoric in order to keep liquidity provisions in place, recent gains seen by the U.S. Dollar could be unwound, as the economy suffers. While the U.S. Dollar is strong now and enjoys a potentially bright future, there are certainly concerns lingering; political division in the United States could be the straw that breaks the U.S. economy’s and the U.S. Dollar’s back in the 2H’13.

This series of eight posts will focus on the major themes affecting currency markets. The fifth post in this series will discuss the recently berated British Pound and why the world’s oldest currency looks, well, old.

This post will discuss the broad ramifications of the Federal Reserve’s exit from the markets on the U.S. Dollar, and the process by which it will be accomplished.

While the S&P 500 climbed by +42.15% over the past three years (since the beginning of February 2010), the U.S. Dollar has been quite flat, yet volatility has been quite high. When QE2 took place from November 2010 through June 2011, the Fed’s total balance sheet size surged by $600B. It’s of no coincidence that during the lead up time to the initiation of the program to its culmination that the ICE Dollar Index, a weighted average of the ‘true’ value of the U.S. Dollar relative to a basket of currencies, fell by -16.38%.

More recently, the U.S. Dollar has exhibited signs of strength during periods at which the Federal Reserve stops injecting liquidity or withdraws from the system, but against a backdrop of significant uncertainty around the world, from growth in the United States and Asia, to political in Europe, and violent conflict across the Middle East. There is a case to suggest that the U.S. Dollar would have gained regardless of whether the Federal Reserve was easing at such a torrid pace, but we think it would be even stronger.

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If the Federal Reserve begins to wind-down its QE3 program, it will likely be in a few steps: first, publicly discuss exit plans (happening now); second, slow the pace of asset purchases from its current rate at $85B/month to $0/month over the course of several months (4Q’13); third, keep the balance sheet steady with interest rates near zero percent (ZIRP) (through 1H’14); and fourth, begin to sterilize (sell the assets) the balance sheet (2H’14 through 2H’16). As this process occurs, because market participants usually front-run policy and act on rhetoric rather than actual policy more recently, the U.S. Dollar is expected to continue its upturn despite the continued expansion of the Fed’s total balance sheet, as it’s clear the stronger U.S. consumer is beginning to support a stronger economic recovery.

There’s a big “if” to this whole equation: the U.S. budget sequester. Yes, the pesky, self-induced dose of austerity that U.S. politicians agreed was the best way to fix the nation’s apparent deficit and debt problems. Could the feckless Congress derail the recovery?

This series of eight posts will focus on the major themes affecting currency markets. The fourth post in this series will discuss why political impasse in the United States could be the straw that breaks the economy’s and the U.S. Dollar’s back.

In the first post, we provided a broad overview of sentiment in the global investment ecosphere, from the perspective of a macro-focused investor – the type of market participant that could benefit by adding Hedgebook into their investing and hedging toolkit. The next two posts will focus on the monetary policies of the world’s largest economy, the United States.

In retrospect, 2012 was a good year for the United States: the economy had recovered from a mid-year lull in jobs growth, with the Unemployment Rate drop below 8% in the third quarter ahead of the presidential elections. While the jobs recovery has been rather meager, there have been some bright spots that are worth discussing as they have emerged as not only bright spots, but strengthening trends that could one day soon force the Federal Reserve to exit the market.

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In the chart above, we highlight the U.S. Advance Retail Sales report amid the Change in Nonfarm Payrolls report for a very specific reason: nearly three-quarters of the world’s largest economy is driven by consumption; the Advance Retail Sales report is the best proxy data available. It’s very evident from the chart above that consumption trends have been leading employment – it led the upswing in jobs growth in early-2010, and once again in mid-2010, while the turn lower in mid-to-late-2011 was led by softer consumption once more. Needless to say, consumption is key for the U.S. economy to continue to grow.

The big question is: can consumption maintain the U.S. economy’s slow recovery? The evidence is there: consumer sentiment readings are near in at multi-month and multi-year highs; wages adjusted for inflation are increasing, meaning that workers have more money in their pocket; the savings rate among households is increasing; and the housing market is showing greater signs of recovery every single month.

We do believe that the U.S. economy will continue to trudge forward this year, albeit at a slow pace, in no small thanks to the Congress in place, whose lower house is always at odds with the Obama administration. Near-term budget cuts will weigh on growth, as they already have in the 4Q’12 (this will be covered in the next post). Assuming that politics don’t get in the way of economic growth, it’s very possible the Federal Reserve sticks to its recent rhetoric, and begins to wind-down its QE3 program at the end of the year. If the economy is strong enough, markets could withstand the liquidity drain. If there’s one instrument that could benefit from a smaller Fed balance sheet, it’s the U.S. Dollar.

This series of eight posts will focus on the major themes affecting currency markets. The third post in this series will continue to discuss the Federal Reserve and the U.S. Dollar.

As the calendar turned to 2013, all was seemingly well: Chinese “hard landing” concerns eased substantially, with growth settling near +8% annualized; the Bank of Japan’s new ultra-dovish mandate under the eye of new Prime Minister Shinzo Abe was sending the Japanese Yen plummeting, reviving the carry trade; peripheral European sovereign yields remained low and relatively compressed to their German equivalents, allowing the Euro to outperform every major currency; and U.S. politicians struck an eleventh-hour deal to avoid the fiscal cliff, the self-induced austerity measures intended to quickly cut the budget deficit.

But those were only near-term developments, 2012, like 2011, was marked by substantial volatility across asset classes, all thanks in part to unstable and unpredictable political issues in Europe. And yet here we are, in mid-February, with equity market in the United States nearing all-time highs, and (gasp!) there’s even talk about the Federal Reserve winding down its stimulus program later this year. With uncertainty so prevalent over the past several years, it’s quite miraculous where global markets actual stand; but it’s also clear that there must be another force at play.

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This exogenous factor, that seemingly has elevated the mood of all market participants, has been the additional liquidity provided by the world’s major central banks, in programs most commonly executed as a variation of quantitative easing, or QE. This process entails central banks increasing the money supply of their currency, for two main purposes: to lend to banks at ultra-low rates to incentivize them to lend the borrowed funds back to consumers and businesses, to help foster economic growth; and to weaken the domestic currency to help improve the competitive export position – a weaker domestic currency makes domestic products cheaper for foreigners. While this second point may be true, the first point, not as much; instead, much of the cheap liquidity has been the ammunition market participants need to partake in risky financial activities, which has sent the S&P 500 on its way to all-time highs.

Certainly, there is some clout to this argument. Over the past three years (since the first week of February 2010), the S&P 500 has rallied by +42.15%, while the major global central banks’ balance sheets (the Federal Reserve, the Bank of Japan, the European Central Bank, the Bank of England, and the People’s Bank of China) have increased by +38.42%. There’s a simple inference: only +3.74% over the past three years in the S&P 500 can be attributed to ‘organic’ economic growth, as the rest has been fueled by ultra-loose monetary policies being implemented across the globe.

But as we said to begin this post, 2013 began on a high note; many of the concerns plaguing the investing environment were resolved or swept under the rug, out of sight, out of mind. As the globe’s major economies improve, central banks will begin to drain out the excess liquidity in the system. Is the global market stable enough to withstand such a series of events?

This series of eight posts will focus on the major themes affecting currency markets. The next two posts in this series will focus on the United States’ monetary and fiscal policies, and how they could upend a slow economic recovery.

Just like everything else in life – from barbequing, to merging into traffic, to releasing new products during certain economic cycles – timing is absolutely crucial in hedging foreign exchange exposure. The best way to know when to hedge or not is by looking at a chart – yes, it’s that simple!

Take the NZDUSD pair from January 2003 to December 2009:

NZD/USD Spot Rate

In April 2005, the NZDUSD moved to new all-time highs, having broken the previous one set over a year earlier. At this time, it wouldn’t have been wise to hedge against further new highs; but taking on a hedge for a downside risk would have been reasonable. The same can be said about the NZDUSD in January 2009 – it had moved to its lowest exchange rate in over six-years – it might not have been appropriate to hedge against further downside risks, but instead more proper to hedge against upside risks (hindsight being 20/20, this would have been a wise idea).

For example, in January 2008, it would have been a good time for a New Zealand company hedge payments made in U.S. Dollars, because were the NZDUSD to depreciate in value, the more money the firm would have to pay. If in January 2008, the New Zealand company decided not to hedge US$10 million in payments due a year later, it would have seen its cost rise from N$12.5 million (NZDUSD = 0.8000) to N$20 million (NZDUSD = 0.5000). By not hedging, the New Zealand firm would have had to pay out an extra N$7.5 million!

The next blog post will illustrate how market positioning can be used in timing.

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