As the fiscal cliff approaches in the United States and the euro zone crisis drags down global growth rates, central banks across the world have been delivering more and more stimulus. The problem, according to David Bloom, head of global foreign exchange strategy at HSBC, is that central banks are having less and less impact on the global economy.
“The remarkable aspect of this spate of easing and expected easing is that it feels rather underwhelming in terms of its perceived implications for the global economy,” said Bloom in a research note.
“It has not, it seems, fostered any greater degree of optimism regarding future economic growth. Perhaps it is simply too early to see such a change in mood come through," he said.
One thing the central bankers have achieved is a rise in investor risk, appetite sending stocks higher since their June low. They have boosting the risk-on brigade's favorite currency, the Australian dollar, which has moved sharply higher against the yen in particular. The question investors need to answer according to Bloom is whether the stimulus will help revive growth or simply signal that they stand ready as the buyer of last resort for risky assets.
“Part of the answer lies in whether quantitative easing (QE) remains potent. Academics have pored over the effectiveness of non-conventional monetary policy and, inevitably, the conclusions vary. But a cursory examination of the financial market reaction to QE suggests a declining influence," Bloom said.
The Federal Reserve’s first round of QE saw the S&P 500 rise by nearly a third, but the second round saw only single digit gains. For the currency markets this debate will determine whether the dollar, or the euro will finish the year in the ascendancy, according to Bloom.
“The weaker economic data is “risk off” and therefore good for the dollar, but QE and its impact on financial assets is “risk on” and bad for the dollar, – this is creating a dollar standoff” said Bloom who notes that disappointing data boosts the dollar but really disappointing data boosts the greenback.
“Intriguing as this dynamic may be, it is not sustainable. Policy responses may help underpin financial asset prices for a period, but in the end they need to reflect the economic fundamentals”," he said.
A day of reckoning is on the way, according to Bloom, when we will either see an improvement in the economy or a big fall in asset prices.
“The risk for the dollar is that we are on the cusp of a paradigm shift for the FX market where the offsetting influences of weak economics and the QE response no longer hold sway," he said.
"Two Catalysts" That Could Change The Dollar
“Instead, we are set to look at the dollar not in terms of its “function” as a high liquidity currency but in terms of its value,” said Bloom, who believes there are two possible catalysts that could significantly change the prospects for the dollar.
“Firstly, the euro crisis has moved away from the disaster scenarios that were in play during most of the first half of 2012. The Greek election has reduced the risk of them leaving the euro," he said.
“The EUR crisis, which has captivated the FX market for so long, is set to become comparatively dull as the market drifts through the summer towards the 20th EU Summit (since the crisis began), scheduled for October,” said Bloom who believes another factor will captivate the market if the euro crisis does not blow up again over the summer.
“Unless Congress can agree on how to avoid this fiscal contraction. In a worst case scenario, a failure to secure any compromise would cut 2.1 percent off U.S. GDP by the end of 2013," Bloom said.
Bloom and his team expect a "reality check" by U.S. lawmakers to help avoid the worst case scenario despite bitter infighting as the deadline approaches.
“This may also put the U.S. credit rating back into the limelight with downgrade worries likely to resurface, in contrast to Europe where governments have already taken painful steps to address their earlier fiscal failures," he said.
“If the focus of the market falls onto the U.S. fiscal position, then weak economic growth will no longer hold ambiguous implications for the dollar. It will simply be negative. It will exacerbate the cyclical pressures on U.S. government finances and intensify concerns about U.S. credit worthiness,” said Bloom.
“We believe recent progress in Europe and the approaching U.S. presidential elections will foster a new paradigm, one which replaces the current ambiguous dollar reaction to weak U.S. numbers to a more straightforward dollar sell signal," he said.