Can't the Fed Pretend to Care About the Dollar?

By Philip Dunham

That may be a bit extreme. Of course the Fed cares about USD, but for now it is on the back burner. Last week, in its statement following the FOMC meeting, Board members effectively capped short rates when the line "including low rates of resource utilization, subdued inflation trends, and stable inflation expectations" was added. (Full text of FOMC statement with changes highlighted on page 4 of PDF.) This addition was an attempt to flatten the yield curve, without raising short rates, by reducing inflation expectations priced into the long end of the curve. In theory, this should bring long rates down marginally. However, markets bushed this off rather handily. The initial response to FOMC in treasuries was curve steepening until 30 year bonds bottomed on Friday following news that U.S. unemployment had reached 10.2%.

Until last week, as was evident by put buying in Eurodollars as a hedge against a spike in short rates, participants were still slightly skeptical of either Bernanke’s commitment to lock down short rates or whether the labor market would improve relative to expectations. Both of those fears were quelled last week by the statement and employment data. On one hand, short rates are so low, the only possible direction is higher. That may be the case from a risk/reward standpoint when looking at just the short end, however it would be contingent of surprisingly positive developments on the labor front as we can rule out the FOMC pulling a 180 and adding some hawkish element to the statement in the foreseeable future. As of now, given enthusiasm in equities, the likely scenario seems to be flattening of the curve via the long end provided buyers of long dated treasuries are willing to take down supply thrown at them by Treasury.

One last element of the statement worth noting was the $25 billion reduction in planned agency debt purchases from $200 to $175 billion. This was a mildly hawkish development. The rationale for which, the FOMC explicitly stated “reflects the limited availability of agency debt”. The statement went on to say that the committee expects agency debt and MBS purchases to be completed in Q1 2010. That said, it does not mean QE will be withdrawn. Simply for now given available data and forecasts no further purchases are necessary but the Fed left its options open by leaving unchanged the statement, “The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”

The ECB meeting was rather boring with few significant developments in growth or inflation outlook. However, in typical form, the ECB’s Trichet was able to find some way of adding a hawkish spin to the statement. This came in the form of a statement regarding liquidity measures implemented in response to the financial crisis. Specifically, Trichet noted,

Looking ahead, and taking into account the improved conditions in financial markets, not all our liquidity measures will be needed to the same extent as in the past. Accordingly, the Governing Council will make sure that the extraordinary liquidity measures taken are phased out in a timely and gradual fashion and that the liquidity provided is absorbed in order to counter effectively any threat to price stability over the medium to longer term.

This is intended to gradually prepare markets for withdrawal of liquidity. Owing to the differences in factors affecting U.S. and EuroZone economies and hence differences in nature of the respective liquidity programs (hte ECB liquidity facilities are not quantitative easing measures while the Fed and BoE programs are) it is important to note that the ECB will be withdrawing liquidity while the fed will simply stop purchasing securities outright while retaining those securities on its balance sheet.

Technically, if EUR/USD can close above 1.5050 it should test 1.5200. On a weekly chart, the cross is approaching overbought, but not historically high levels. Near term support is 1.4900. Despite its potential to move higher, it must be acknowledged that long term risk reward is not favorable at current levels given the move from roughly 1.2500 since March. EuroZone has few catalysts this week. Monday, German foreign trade was lower than expected at €9.9 billion vs. expectations of €11.2 billion but EUR/USD rose regardless as the risk trade was back in vogue.

The BoE, in a bipolar episode decided to increase its asset purchase program by £25 billion to £200 billion after deciding not to increase the program at its prior meeting. While an expansion of QE should be negative for the currency that is being devalued, the market had priced in a 50 billion increase in QE and GBP readily caught a bid. The BoE continues to proceed rather aggressively albeit somewhat unpredictably in its implementation of QE. The pause in QE expansion may have been an attempt to splash a bit of cold water in the face of traders short GBP which had built a sizable speculative position in GBP/USD in late September-early October. The £200 billion of asset purchases should be completed in approximately three months. From there, similar to the Fed, the BoE will leave its options open by keeping the scale of the program under review. The rationale for expansion of QE was obviously the weak U.K. GDP data two weeks ago.

I can’t help but wonder what the longer term implications of QE are, particularly considering inflation had been surprising higher than expectations earlier in the year. Additionally, a story from Bloomberg noted that Fitch has fired a “warning shot” that the U.K.’s credit rating is most at risk of all AAA rated sovereign debt, which is ironic and a bit comical given Gordon Brown is contemplating a £1 billion helicopter order. The Fitch comments are something worth contemplating. What is clear however, is that the notion developed countries will control public spending during recession is laughable.

Technically, GBP/USD has had solid support since last week from around 1.6300. Monday, it opened moved higher with broad USD weakness crossing above 1.6800 and closing slightly below that level. Tuesday, it was able to shake of the credit rating warning from Fitch, trading as low as 1.6600 and rebounding to close unchanged at 1.6739. So far this week price action is consistent with further upside to at least 1.700. Wednesday, the focus will be the BoE’s quarterly inflation report.

The U.K. budget situation offers a perfect segue. Shall we take a look at Gold?

November 3 India announced it had purchased 200 metric tons of gold from the IMF between October 19 and 30 at market based prices. This puts the RBI cost basis somewhere between 1,065 and 1,029. Although I had expected a near term correction to approximately 1,000 last week before moving higher, we at Davian Letter have reiterated over the past year that the floor under gold continues to edge higher. The reasoning behind the thesis is rather simple. In responding to the global financial crisis, major developed world countries will devalue fiat currencies via fiscal and monetary expansion to stimulate their respective economies. That said, gold long position is getting crowded. 53.6% of COMEX open interest is speculative long while 7.5% of speculative traders are short. I will concede that futures only track spot prices, however futures should reflect sentiment of the more broad gold market as a whole. Judging by COMEX positioning, without an influx of new traders that are not typical participants in the gold market, there are few additional traders to initiate additional long positions. So I’ve noted the long term case for gold as well as the fact that the trade is becoming crowded but fundamentally it is difficult to make a case to fall in any meaningful way below 950 at absolute lowest, but more likely support is 1000.

AUD/USD continues to defy gravity, but for good reason. Interest rate expectations had become a bit extended in late October after the RBA meeting November 2 when some had expected a 50bp rate hike but were disappointed by only getting 25bp. However after correcting to around 0.8950 enthusiasm for the highest rates of the major currencies re-asserted itself, the cross strengthened to close at 0.9304. given relative strength and Australian unemployment to be released tomorrow, AUD/USD should set highs at levels not seen since July 2008.

USD/JPY continues to trade based on yield differentials and as long as U.S. short yields decline, JPY will strengthen. Simple as that. For the week ahead, the cross should trade sideways to lower.

Taking these factors into account, broadly, USD upside is limited. Interest rate differentials and outlook given interpretation of the FOMC statement does not support sustained strength in USD. The G20 meeting did not help USD’s cause after ministers made no mention of USD weakness and only reiterated commitment by member countries to keep stimulus measures in place until the global recovery is on solid footing.

Disclosure: None

Comments

[aussiereader4:]

Why should they pretend to care about the US Dollar?

Nov 12 03:39 AM

[damienhaas:]

I wonder why Fitch did not warn that US AAA rating are in danger of downgrading, just UK?

Nov 12 03:58 AM

[geohjr:]

Interesting to hear Geithner deffending the importance of the strong dollar in Asia this am.

Here's what I got out of it which is kinda circular and contradictary ; We 're concerned about the strength of the dollar, the deficit and the current trade inbalance.

Nov 12 10:40 AM

[Anthony Davian:]

Yeah, the entire admin trots around like the US will not be downgraded and just like you stated, the UK was downgraded.


On Nov 12 03:58 AM damienhaas wrote:

> I wonder why Fitch did not warn that US AAA rating are in danger
> of downgrading, just UK?

Nov 12 01:36 PM