Fed and the Dollar

Several forces had begun working against the US dollar over the past couple of weeks. Our work has tended to emphasize the sifting interest rate differentials, market positioning and technical factors. The FOMC statement further pushes the market in the direction it was already headed.

The market’s response to the FOMC statement, taking 10-year Treasury yields down 13 bp with more follow through in today, and new record low 2-year yield seems as if the Fed announced that it was indeed embarking on what has been dubbed QEII. Indeed a Reuters poll of primary dealers found 10 of 16 expect the Fed to buy more Treasuries compared with 9 0f 16 at the start of the month. Seven see the Fed beginning as early as Nov. The Fed’s heightened concern about deflation (the undershooting of inflation) probably has received the most attention.

Outside of the boilerplate reference to the high levels of unemployment, the Fed did not mention the difficult addressing this part of its mandate. On one hand this may take some of the focus off of the “significant deterioration” bar for additional easing and the market’s focus on the US labor market and shift it toward the inflation and inflation expectation reports. However, many readings of inflation and inflation expectations do not appear all that worrisome. The core PCE deflator stood at 1.4% year-over-year in July. The Fed’s informal target is thought to be 1.70%-2.0%. The 5-year/5-year forward that the Fed has cited in the past as measure of inflation expectations it looks at has risen from about 1.85% in late August to almost 2.5% as of Monday, the eve of the FOMC meeting. The breakeven of 10-year TIPS is about 1.86%, up from about 1.46% in late August. The 5-year break-even has been more subdued. It bottomed in late August near 1.10% and stands just above 1.21% now.

Of course, there is a feedback loop and market expectations are not set independent of policy action. In effect the rise in inflation expectations has taken place alongside expectations of new Fed measures. If the market is behaving as it the Fed has already begun QEII, perhaps with its $28 bln purchases of Treasuries since late August as it recycles the proceeds from its mortgage holdings. From the consensus point of view there are three questions: how large of a program, when will it begin and how effective will it be. Tentative consensus answers appear to be incremental size, with most expectations seeming to fall between $500 bln and $1. Trillion that can be announced as early as the next FOMC meeting, the day after the Nov mid-term elections, and most dod not seem to think it will be particularly effective.

In addition to the Fed, the BOJ and the BOE may also be moving to additional measures. What still appears to be unsterilized intervention by the BOJ is thought to be followed in early October by some additional measures. The minutes of the BOE recognized that it too might have to provide more support, even though, like at the Fed, there is a single dissenter. Given the current account positions, new QE may weigh on sterling more than the yen. Meanwhile, the market has begun probing the BOJ’s resolve.

Investors should be prepared for additional dollar decline in the coming weeks. Much of the euro’s advance has thus far appears to be short-covering. AS of last week, the net speculative position at the IMM was still short the euro. There is scope for that market to accumulate a long position and given the interest rate differentials, have the greatest incentive to do so this year. The euro has moved above its 200-day moving average for the first time since January (~$1.3215). The Swiss franc did so back in mid-July and sterling traded with its 200-day moving in late July and Aug, but was back below it earlier this month. More recently it has broken back convincingly above it (~$1.5365). One of the technical signals that helped boost our confidence of the dollar’s rally earlier this year was that the 50- and 200-day moving averages had crossed in a negative for these currencies. These averages have now crossed in a positive direction for the Swiss franc (mid-August) and sterling (early Sept). The euro’s averages have not crossed yet, but will likely do so before the end of the month.

I will post a larger discussion of these issues and new targets will be later this week, but to anticipate it, for our purposes here, based on our technical and fundamental analysis, we will suggest the euro has potential to rise into the $1.38-$1.40 area and sterling can retest the $1.60 area.