Monetary Easing, The Counterfactual, And A Lower Dollar In The Balance

Includes: FXA, FXB, FXE, SPY, UUP
by: Dr. Duru

Federal Reserve Chairman Ben Bernanke has made the case for further monetary easing simple and straightforward. Unless some miracle happens in the economy to send growth hurtling upward (presidential campaign promises, like Mitt Romney's pledge to generate 12 million jobs in four years, do not count!), the Fed will act. I am not going to predict how, when, or why, just that monetary easing in some form will happen. I reiterated the case in "Little New News From Jackson Hole But Market Readies For Action Anyway." I am reading and hearing critics complain that further easing will not accomplish anything, that it will not generate more growth.

However, I think these critics are missing the counterfactual case that forms the foundation of the Federal Reserve's bias to act. The Federal Reserve is becoming more afraid of what could happen if it does NOT act: long-term unemployment getting longer and eventually undermining the economy to the point of a new recession. If no additional boost to growth happens post-easing, critics will feel vindicated, but they will be neglecting the counterfactual case for the Fed's action.

In fact, we KNOW the Federal Reserve does not think it can generate much more economic growth on its own. At Jackson Hole, Bernanke reiterated three impediments to economic growth: a weaker than expected/desired housing recovery, poor fiscal policy, and the European sovereign debt crisis. The last two headwinds are essentially outside the Fed's sphere on influence.

I have posted several pieces making the case that the housing market is finally bottoming. The Fed knows this recovery is underway (see the snippets from the last Beige book "More Positive Milestones For The Residential Housing Market") and must be particularly eager to make sure the nascent recovery does not fizzle out because of worsening employment prospects.

I think fiscal policy is the source of the Fed's greatest frustration given the on-going inability of the Democrats and Republicans to cooperate in good faith. It is telling that Bernanke has repeated the same prescription for years to no avail. His statement from Jackson Hole also included observations that fiscal policy is actually tightening with reductions in employment and spending AHEAD of anything catastrophic that may come from the "fiscal cliff" (emphasis mine):

…fiscal policy, at both the federal and state and local levels, has become an important headwind for the pace of economic growth. Notwithstanding some recent improvement in tax revenues, state and local governments still face tight budget situations and continue to cut real spending and employment. Real purchases are also declining at the federal level. Uncertainties about fiscal policy, notably about the resolution of the so-called fiscal cliff and the lifting of the debt ceiling, are probably also restraining activity, although the magnitudes of these effects are hard to judge. It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs. However, policymakers should take care to avoid a sharp near-term fiscal contraction that could endanger the recovery.

Now working in the Fed's favor is the recent drop in the dollar (NYSEARCA:UUP). On September 7, the dollar index finally cracked below its 200-day moving average. The dollar index's "QE2 reference price" turned out to be a real cap to further appreciation. Now it looks ready to continue sliding lower as panic over the euro (NYSEARCA:FXE) recedes thanks to the ECB's likely move to buy bonds (pending German approval and requests for aid).

The dollar index breaks down below its 200DMA and looks headed lower

A lower dollar takes some of the pressure off the Fed to act. A lower dollar indicates there is no pending liquidity crunch rushing for safety and American exports get slightly more attractive based on price.

The euro's recent surge is largely responsible for the dollar's plunge.

The euro surges to a near 4-month high

A lower dollar has even allowed the Australian dollar to surge (NYSEARCA:FXA). The currency bounced near perfectly off flatline for the year and seemingly only the 50DMA stopped the currency's advance against the dollar on Friday.

Australian dollar rebounds against the U.S. dollar

One of the oddities about the prospects for further monetary easing is that it might come at a time the stock market is doing just fine. The S&P 500 (NYSEARCA:SPY) is now at 4+ year highs. More easing will certainly push the index higher and likely even bolster carry trades which feature borrowing cheap dollars for buying equities (and other assets of course). Such borrowing will effectively pressure the dollar even lower.

The S&P 500 pushes to fresh 4+ year highs

This is not a time to fight the Fed (I have proposed a method for short-term trades my latest "T2108 Update"). Central banks around the world continue to ease policies and likely see a great opportunity to push markets and asset prices higher as anxieties ease over Europe. Even the pre-election trade is in full throttle now. Dips should continue to get bought; the wary can build hedges on rallies. I am short the euro for now, but as soon as it closes convincingly over the 200DMA against the U.S. dollar, it will even be time to get (and stay?) bullish on the euro. At that point, the dollar index will likely begin a new, sustained downtrend. The British pound (NYSEARCA:FXB) has already broken out against the U.S. dollar, and I still recommend buying the dips there. It goes without saying that gold and silver should continue to recover and rally.

Be careful out there!

Disclosure: I am long GLD, SLV, PAAS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In forex, I am also short EUR/USD.