Understanding the FX Price Action

The price action in the foreign exchange market stands in sharp contrast with yesterday’s key developments.

First, like they did earlier this year, the Reserve Bank of Australia surprised the market by apparently signaling the need to hike rates and then failed to deliver. This led to a wash out of some of the late buyers of Australian dollars. At one point the currency was off about 2%. It has now not only fully recovery but it is made new two-year highs today, just shy of the $0.98 level.

Second, Brazil doubled the tax on foreign purchases of Brazilian bonds to 4%. The Brazilian real strengthened yesterday to new two-year highs.

Third, South Korea announced it was audited banks foreign exchange transactions and although this initially weighed on the won, the won completely retraced those losses and now is at its best level against the dollar since May.

Fourth, the BOJ adopted zero-interest rate policy and indicated another JPY5 trillion expansion of its balance sheet, and bypassing traditional limit of JGB holdings to bank note issuance. The yen initially weakened, but has also recovered to trade at its best level since the Sept 15 intervention.

There may be two general explanations for this counter-intuitive price action.

First, the steps taken are too small given the size of the countervailing forces. For example, will cutting Japan’s overnight rate to zero from 10 bp really break the back of deflation? Is the JPY5 trillion (~$60 bln) in additional asset purchases manage to break the liquidity trap in Japan? If Japan just eased policy on the margins and the market is pricing in a near certainty that the Fed is soon to ease policy, does it really matter that much that the RBA did not hike rates yesterday, especially given that it is still signaling the need for higher rates?

The strength of the Brazilian real despite the increase in the fixed income transaction tax may reflect the elevated profit expectations of the latest investors. Policy makers had signaled the risk of the tax for the last couple of weeks.

Second, these factors are not really the main drivers of the current moves in the foreign exchange market. The key driver is increased likelihood of new easing of US monetary policy. The number of Fed officials that have spoken this week clearly gives the impression that Bernanke has been able to put together a consensus for the shift in policy he suggested at Jackson Hole. The kind of easing of monetary policy that is apparently being discussed seems worth more than a 25 bp Fed funds rate cut. NY Fed President Dudley suggested earlier this week that $500 bln of Treasury purchases is tantamount to 50-75 bp worth of easing, depending on the holding period.

The other driver, partly related to this, is the diversification of the intervention proceeds out of dollars. Yesterday’s international developments do not really alter these drivers. That said, there is talk in the markets today that the G20 by seek an agreement from Asia (not singling out China) to allow their currencies to appreciate. In fact, all Asian currencies, but the Hong Kong dollar, have appreciated this year, with the Thai baht’s 11.5% leading the way, followed by the Malaysian ringgit's 10.8% gain.