Divorcing Europe From The Fed And Dollar

 |  Includes: FXB, FXE, UDN, UUP
by: Tim Clayton

The two most important European central banks will announce their latest interest rate decisions on Thursday. Medium-term policy divergence will continue to support the dollar as, in relative terms, both the eurozone and UK will have to run looser policies than the Fed to support their economies.

This month, the most likely outcome is for a dovish tone with increased forward guidance on maintaining a very loose policy while resisting actual changes. With the euro and sterling liable to drift weaker into the decisions, the best strategy from a risk/reward perspective looks to be establishing short positions against the dollar at the 1.3070 and 1.5250 areas respectively, aiming to establish no-lose trailing stops ahead of the rate announcements.

The Federal Reserve decision to aim for a scaling back of bond purchases could still be derailed by evidence of a fresh slowdown in the economy. A weak payroll report this Friday would certainly trigger speculation over a reversal, but the intention for now is clear as they look to scale-back bond purchases in September. European central banks will also have to tailor their polices to fit in with the new Fed landscape and shift in capital-market sentiment.

The net result of Fed rhetoric has been additional pressure on Europe. From a positive perspective, gains in the dollar have pushed the euro and sterling weaker, which will provide some limited benefit to competitiveness. This potential positive impact will be more than offset by the rise in bond yields seen since the latest Fed meeting. UK benchmark 10-year yields have increased from record lows below 2.0% to around 2.5% while eurozone peripheral yields have also risen.

This is particularly dangerous for the eurozone peripherals as, even with favorable tailwinds, they are finding it impossible to pull out of recession. A further increase in yields would be very damaging economically and, even more seriously, would trigger renewed damage to the banking sector. The ECB will also be looking very anxiously at the unused OMT program. The bluff has worked its magic for 12 months since Draghi's "save the euro" speech last year, but markets are closer than ever to calling the bluff, especially with potential limitations on the program from the German Constitutional Court. The ECB will have to try and reverse or at least cap any rise in long-term yields.

There has been some ECB kite flying ahead of this week's meeting with some reports that a new bond-buying program could be introduced. This looks very unlikely at this stage, but there is a strong probability of a dovish stance on Thursday. There are likely to be strong hints that policy will remain very loose for the foreseeable future in an attempt to get long-term interest rates down again.

Media attention surrounding the latest Bank of England meeting will be extremely high as it takes place in the first week of Carney taking over as governor from King. There is little doubt that Carney will want to stamp his authority on the bank through a radical overhaul of structure as well as policy to improve the underlying economic performance. It is also likely that he will look to push for a more aggressive monetary policy with increased forward guidance. Carney is likely to look for additional quantitative easing and there will be a temptation to rush into the first meeting with all guns blazing.

It will, however, also be essential to form a consensus within the MPC. Any attempt by Carney at this stage to boost quantitative easing in the face of majority opposition could easily fail and would also be extremely damaging from a medium-term perspective. Splits and internal division now would risk becoming a lame-duck governor almost from the start. Overall, Carney is likely to issue a statement promising to boost the UK economy, but resist the temptation to take an even more aggressive stance at this point.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.