The Yellen Bubble Or What Keeps The Euro Aloft

Includes: FXE, UDN, UUP
by: Joseph Trevisani

By almost every comparison the dollar should be rolling up its European competitor. American economic growth is stronger, the Federal Reserve is tightening rates while the European Central Bank is looking for novel ways to ease and the returns on Treasuries have risen steadily since early summer. Yet the euro has been trading the same range for four months since it broke higher after the September 18th FOMC meeting.

Euro strength is really dollar weakness. The Federal Reserve's on and off taper last fall, uncertainty over the pace of and size of the reductions in securities purchases and questions about the policy intentions of incoming Fed Chairwoman Janet Yellen have rendered markets unwilling to take a strong pro-dollar position regardless of fundamental economic and interest rate comparisons.

Annualized growth in the U.S. was 4.1 percent in the third quarter of 2013; many estimates for the fourth quarter are rising past 3.0 percent. The World Bank projects 1.8 percent American GDP growth for the entire year and 2.8 percent for 2014. The Federal Reserve projects 2.9 percent to 3.1 percent GDP growth for 2014.

Quarterly economic growth in the eurozone dropped to 0.1 percent in the third quarter of last year from 0.3 percent in the second. The World Bank anticipates a 0.4 percent contraction for the entire year and a 1.1 percent expansion in 2014. The ECB forecasts 1.1 percent growth for 2014.

The Federal Reserve began a rate tightening cycle at December's FOMC meeting with a $10 billion reduction in its $85 billion a month of securities purchases. The governors are denying that the bank intends higher rates. They promise that the Fed Funds rate will remain low for an extended period and that their policy is data driven and can be reversed. But the gradual end of MBS and Treasury purchases will result in higher commercial interest rates. Fed rhetoric cannot change the fact.

By May 2013 quantitative easing had secured 30 year mortgage rates at 3.40 percent, well below their 15 year average of 5.60 percent. These mortgages were 4.34 percent last Friday, according to Almost two-thirds of the rise from 3.40 percent occurred after May 22 when Chairman Bernanke first mentioned the possibility of ending quantitative easing purchases.

Last May the rate on the generic two-year Treasury was 0.20 percent, less than a tenth of its 2.61 percent 15 year average. The bond closed at 0.34 percent on Friday. Two-year rates have been affected least by the pending end of quantitative easing, but two thirds of the gain has come after Bernanke's May notice.

The ten-year bond yield was at 1.63 percent last May last, less than half its 3.98 percent 15 year average. On Friday ten-year rates were at 2.72 percent with almost two-thirds of that rise occurring subsequent to Bernanke's May 22nd speech.

The ECB has the opposite policy. With eurozone economies except for Germany in a bog, the bank has been intent on lowering interest rates. It cut its refinance rate by 25 basis points in November to 0.25 percent, its third 0.25 percent cut in the past 18 months.

Last May President Mario Draghi suggested that the ECB might take the unprecedented step of charging banks for cash deposits. In July he promised to keep interest rates at or below current levels (then at 0.5 percent) for "an extended period". In December Mr. Draghi said that rates would stay low for the foreseeable future and that officials continued to debate whether deflation and the EMU's weak economy required negative interest rates or other measures.

Though the ECB is forbidden by charter from financing government deficits or undertaking the equivalent of the Fed's quantitative easing program, Mario Draghi has repeatedly said that "all available tools" will be considered to foster the euro-area's recovery.

So while the historical ingredients of currency movements, the state on the national economy, the direction of central bank policy and the return on sovereign debt, are pointing toward the U.S. currency, the euro closed on Friday 6.4 percent higher against the dollar than it was on last May 22nd when the Fed began its tapering discussion.

There are two primary reasons for the dollar's relative weakness. The first is that there are serious restrains on existing ECB and Fed policy despite their clearly opposite intentions. The second stems from the uncertainties created by the Fed when it wrong footed the markets twice in September and December combined with unanswered questions on where Ms. Yellen will take Fed policy.

Mario Draghi wants to provide more liquidity to EMU but his bank is out of easy options. A rate reduction from the present 0.25 percent would have little economic or financial effect, though it would devalue the euro.

The ECB cannot force market rates down with direct bond purchases as the Fed has done. Another round of LTRO (long term refinancing operation) would do nothing to lower market interest rates. Even negative rates that charge banks a fee for deposits cannot create commercial lending where there is little demand. Though the ECB may want to lower interest rates it has limited capacity to do so.

The Fed has a different problem. It has started to withdraw its extraordinary liquidity provisions, but it has been at pains to stress the tentative nature of this policy. If the economy weakens, if job growth slows, the FOMC could halt or even reverse its quantitative easing reductions. The negative returns on equities so far this year will not comfort a Fed worried about the impact of higher interest rates on the economy and on a slowing housing market.

The Fed taper, if it continues, will produce higher U.S. interest rates; the ECB may yet devise a way to lower market rates, but there is no certainty about the timing or success of either policy. The logical effect on the dollar of these opposite rate policies has been stymied by doubts about each bank's ability to carry them out.

The dollar did move sharply higher last summer from June 19 to July 10 in response to Fed Chairman Bernanke's warning on the impending end of quantitative easing. Mr. Bernanke first broached the possibility on May 22nd, reinforced the warning on June 19th and then seemed to qualify the notice on July 10th after interest rates had moved sharply higher. From 1.3390 on June 19th the dollar moved higher and the euro lower to 1.2764 by July 10th, but then, with the Fed qualification it reversed. By September 18th when the FMOC was universally expected to begin the taper, it was back to just about where it had been on June 19th, 1.3358. In the event the Fed declined to reduce its purchase program and the euro soared, to 1.3540 that day and to 1.3831 by the end of October.

Currency traders are wary. The Fed governors said in September that their primary concern was the economic effect of a rapid rise in interest rates. But the demonstration that they were willing to defy market expectations they themselves had created was a warning that has gone home.

Since the Fed began the taper just three months later in December, again belying market expectations, it seems likely that the Fed action in September was meant as an admonition, rather than as a response to changed economic circumstances. Had the U.S. economy really improved so much from September to December that reducing liquidity was no longer a danger?

The end of quantitative easing is not a foregone conclusion. Doubts about the timing and extent of the taper are intended to keep markets as quiet as possible. Traders are on notice that if the Fed thinks current policy requires adjustment it will not hesitate to act.

There is one final consideration that has helped keep a lid on the dollar, call it the Yellen effect.

Ms. Yellen has made numerous public comments about the primacy of unemployment in her policy considerations. Fed rhetoric is a powerful tool, particularly at this juncture, with the deliberate whipsaw delivered to the bond and currency markets last summer. Will she try to sway the governors toward more not less monetary accommodation?

Having been burned twice by Fed policy makers, credit and currency traders have dampened their inclinations to sell bonds and buy the dollar until they have more substantive indication of Fed intentions.

The simplest proof that the governors intend to end quantitative easing this year would be a $10 billion reduction at Wednesday's FOMC meeting, the last of Mr. Bernanke tenure. Stronger evidence would be a reduction at the March 19th conclave chaired by Ms. Yellen.

But with the recent rout in emerging markets, increasing concerns about whether China can successfully withdraw its own massive liquidity support without crashing its financial system and the sharp drop in global equities, a reemergence of the dollar and dollar assets safe haven trade could make the central bank guessing game moot.

The Fed may yet achieve both lower rates and a stronger dollar without having to incessantly bandy the markets between policy and rhetoric.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: I wrote the article. I am chief market strategist at WorldWideMarkets Online Trading.