This week creates a 'Tale of Two Feds' scenario with the US Federal Reserve speaking on their interest rate decision on Wednesday and the European Central Bank (ECB) doing similar on Thursday. With the two banks seeing differing data in the economy and having different mandates in mind, the expectation from these two meetings should differ as well.
The US economy grew at 1.5% last quarter, which is a slowdown from the beginning of the year. This has sparked speculation of another round of QE from the Federal Reserve which has moved QE positive assets such as equities, the Australian dollar, and gold all higher over the past few weeks or month. In this scenario however, the Fed should disappoint these expectations by not announcing any stronger language than has already been said.
There are several reasons, one being that the data out of the US is lower than in the beginning of the year, but not any real cause for concern. The Fed should also conserve its ammunition for later in the year when the spat between politicians over budget talks occurs. Should the talks have a desirable resolution, confidence could boost the economy on its own and no more stimulus will be required. In reality the talk will create more uncertainty and the budget cuts of next year will push the economy into a recession. Being able to act then, with an open ended QE policy, will help keep confidence in the markets that there is a floor on assets and fears of a double dip will be subdued. Should the Fed act too early and set limits on the amount of stimulus needed, a negative outcome from these talks could pale the amounts of easing that the Fed has enacted for the time frames they set out.
On the other side of the Atlantic the story is a near mirror image. The European markets have seen a huge turnaround in fortunes since Mario Draghi, the ECB president, came out last week saying the European leaders will "do what it takes to protect the euro". Time is now calling this bluff as well as objections with the German government as to the nature of these remarks (judging by the yields on Spanish and Italian debt, many believe to mean more asset re-purchasing). Decisive open ended action will need to be taken in the Euro zone, with an open ended stimulus plan being put in place as well.
There are talks that the ESM should get a banking license in order to borrow whatever funds are needed to support the bond yields of sovereign nations within the currency bloc. This will put a floor on the costs of borrowing in these countries which should also lower the currency and make euro countries more competitive on a global scale.
These measures could differ in reality, having adverse market effects over the next couple of months. Should the Fed come out with stronger language on Wednesday pointing to more stimulus in the near term, it will no doubt be positive for the markets in the near term, but will leave little action to be taken should liquidity dry up in the beginning of the year if the budget talks don't make any headway.
For this trade I would look to add position go higher yielding assets like the Australian and Canadian dollars. Also a purchase of a gold ETF would not be a bad idea as well. Equities, while a rally would most likely result from the announcement, would be on shakier ground going into the end of the year.
The European situation will be more pronounced; inaction by the governments to back Draghi's statement will see the yields of Spanish and Italian debt rise again, the equity markets drop, and the euro go back to its new funding currency status. For these measures I would look to be bearish on equities in the Euro zone, and short the euro. I would even look to short German bonds as inaction will strain the viability of the euro itself, and action will result in the closer integration of the European economies.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
