Waiting for Big Ben

The US dollar remains soft, but within yesterday’s trading ranges, as the market awaits Federal Reserve Chairman Bernanke’s speech early in the North American session (8:15 EST/12:15 GMT) on “Monetary Policy Objectives and Tools in Low Inflation Environment”. The market is hoping to glean more insight into the likely Fed actions.

Headline risk also stems from US economic data today with a string of reports and the possibility that the US Treasury releases its report on the currency market, which is due today, though is often late. The over-extended nature of the dollar’s decline, extreme sentiment readings, and the crowded nature of the trade in general, makes short-term participants reluctant to chase the market. However, but the negativity related to perceptions that rather than leading the recovery from the crisis, the US may now be lagging has not dissipated, encouraging selling into modest dollar bounces.

Bernanke’s speech is more important than the US economic data being released today. The prospects of a new round of long-term asset purchases by Federal Reserve has been a major driver not only fueling dollar sales, but also contributed the lifting commodities, emerging markets and equity markets in general. Speculation in some quarters that Bernanke is about to step away from QEII which has been heard in recent days seems far off the mark.

Given expectations, fueled in part by Bernanke himself, are so strong, with surveys pointing to upwards of 90% anticipating QEII, not to deliver would be potentially more disruptive than the risks associated with long-term asset purchases. Fed officials have also identified other measures that could be taken, such as a formal inflation target and more emphasized commitment to keep rates low for longer.

Banks are holding around $1 trillion in excess reserves with the Federal Reserve. They are being paid 25 bp to do so. Few seem to be asking why. The banks did nothing to earn those excessive reserves. The Fed simply granted them. The 25 bp does not sound like a lot, but it is more than the banks could get by loaning them out in the Fed funds market. It is more than the banks could get by buying 3, 6, and 1-year Treasury bills. If the Fed wants to moderate the ongoing reduction of bank’s balance sheets, maybe it should stop paying them keep the funds with them. Buying T-bills would increase money supply aggregates and have some positive albeit modest impact.

In any event, the combining the surveys with the price action, it would seem that the market has priced in QEII into the short-end of the curve as the US 2-year yield and the implied yield of Dec Eurodollar futures, as representative, have not made new lows this week.