The Next 36 Hours

The US dollar is trading heavily though within the recent ranges against most of the major currencies ahead of the conclusion of the FOMC meeting which is widely expected to result in a new round of long-term asset purchases.

The thunder today has been stolen by the Reserve Bank of Australia. Last month it defied market expectations by not raising rates and defied expectations again today by hiking rates 25 bp to 4.75%. This sent the Australian dollar to new multi-year highs just above $1.00. There is talk of a barrier that may offer resistance in the $1.0040 area.

Euro zone PMI was stronger than last week’s flash reading and this helped the euro return to the $1.40 area. A disappointing construction PMI in the UK (51.6 vs 53.0 consensus), the weakest since February saw sterling lose ground on the crosses, reinforced the cap near $1.61. The yen is largely sidelined and the dollar has been confined to about a 30 tick range against it.

The US midterm election is today. The Republican Party needs to pick up a net 39 seats in the 435-member House of Representatives to wrest control from the Democrats. Many political insiders project them winning net 50-60 seats. The Republicans picked up 54 seats in the 1994 midterm election, while the historic landslide was in 1938, when the Republicans picked up 72 seats.

In the Senate, the Republicans need a net 10 seats capture the upper chamber. Insiders project they may fall shy with 6-8 seats. On one hand, the stronger the Republicans do, the more Obama’s agenda will be curtailed and/or repealed. Fiscally, tax cuts would be extended and spending cut. On the other hand, this electoral cycle has featured the rise of the Tea Party and there is some risk that the stronger the Republican victory today the more difficult to may be to reconcile the two wings of the Republican Party. The dollar does not show as strong of a cyclical pattern in the year after the midterm election.

Tomorrow’s FOMC meeting overshadows the election in the capital markets. Two key variables are the size of the long-term asset purchases and the pace in which they are purchased. A Bloomberg poll found that of 53 respondents, 29 expected a $500 bln program to be announced, 7 expected monthly purchases of $50-$100 bln without a specified total, 12 expected up to $500 bln and 5 did not specify the amount. In terms of pace, 7 do not a time line to be announced, 9, expect the purchases to last three months, 17 expected three-six month duration, 9 expected six months to one year, 5 expect through next year, and 6 did not specify a time frame. We suspect there is headline risk regardless of what the Fed decides.

My points have been three-fold: 1) outside the headline risk, much of QEII has been priced into the dollar with its nearly 7% decline on the Fed’s major trade-weighted index, 2) QEII should be understood as an insurance policy not life support, 3) while some monetary/financial variables may improve, the impact on the real economy is not clear and ultimately rests on financial actors respond.