The 2008-2011 periods of quantitative easing by the US central bank (QE1 and QE2) corresponded with a dramatic improvement in global risk sentiment.

Under such conditions, the NZD/USD exchange rate strengthened significantly and the NZ 10yr swap rates rose moderately. We expect a similar response to any future bouts of QE, but the converse is likely to be true until such QE is signalled.

The spectre of QE3 has been raised during the past few weeks. The US economy has stalled, the European fiscal crisis has deepened, global asset markets have been beset by panic selling, and funding channels have been constricted.

However the Fed will probably want to see core US inflation turn lower to around 1% before acting, which means action this year is unlikely. That timeline may shorten if markets become dysfunctional to the point they are affecting the wider economy, although a signal as early as the Kansas City Fed's annual conference at Jackson Hole on 27 August is unlikely. That said, we can look at the periods during and around QE1 and QE2 for any obvious behavioural patterns in NZ interest rates and the currency, and use that for guidance ahead.

The attached chart shows the period from QE signal to QE termination in grey. QE1 was announced in November 2008 and was expanded in size and breadth of instrument in December 2008, January 2009, and March 2009, before ending in March 2010. The first iteration had little impact on markets but by the time MBS purchase intentions had increased to $1.3tr, risk sentiment clearly started to improve. We show the S&P500 (black) as a global risk sentiment proxy, and note that it bounced strongly once the business end of QE1 was in progress. The NZD and NZ 10yr interest rates followed suit. NZ 10yr swap spreads are broadly directional with outright yields and behaved predictably. The period from the tail end of QE1 until QE2 was signalled was characterised by uncertainty and a slump in sentiment. When QE2 was announced at the Jackson Hole conference in August 2010, a rebound in sentiment occurred.

With the cessation of QE2 in June, risk sentiment has gradually deteriorated, reaching a selling climax during the past week. Should the current QE-less period result in similar market behaviour to that between QE1 and QE2, the NZD/USD exchange rate and the NZ 10yr swap yield will probably fall further. NZ swap spreads, though, will probably buck the trend, NZGB's continuing to attract interest in a fiscally challenged world. The NZ 2-10yr swap curve may initially steepen a little further as the front end reduces RBNZ expectations and reaches an anchor level of around 3.10-3.20%, but should then flatten as longer maturity yields respond to weaker risk sentiment.

Imre Speizer,

Westpac Global Strategy Group

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