Ready to Twist or Shout?

Contrary to my expectations, the US dollar is headed into the conclusion of the FOMC meeting bid though within recent ranges.  I had expected some position adjusting given the extensive dollar longs built over the past couple of weeks, especially against the euro.  

There are couple of factors that might help explain the dollar's general tone:

The minutes from BOE's meeting earlier this month lowered the boom on sterling.  Although no one joined Posen for a extending asset purchases, the tone of the minutes clearly showed members were moving in that direction.  New asset purchases by the BOE looks increasingly likely later this year or early next year at the latest.  The economic weakness coupled with ideas that inflation is mostly due to transitory issues, like the past rise in commodity prices, the past depreciation of sterling, and administrative price increases, including taxes, like the VAT, and other fees.

Another way of thinking about it is that the BOE has in practice suspended its inflation target.  It has not hiked rates despite the persistence of inflation above target and the numerous letters.  The fiscal drag appears set to increase, as the government shows little sign of relaxing its austerity push and the Chancellor seemed to welcome more economic support from the BOE.  

The main highlight from today's North American session will be the conclusion of the FOMC meeting.  An extension of the maturity of the Fed's Treasury holdings is perceived to be as done of a deal as these things get.  One point that strikes me that many have missed is that the first Operation Twist was meant not just to stimulate the economy in a non-inflationary way but also meant to lend the dollar support within the Bretton Woods.  The downward pressure on the dollar at the time was reflected in the upward pressure on gold prices.  

Generally speaking, the less the Fed does, the better for the dollar.  Passive extension of maturities via recycling MBS proceed may be more dollar supportive than an active Operation Twist of selling short-term maturities, which may be more dollar supportive than QE3.  There is a reasonable chance the Fed also cuts the interest paid on excessive reserves, but what might amount to 1 bp a month cut is unlikely to get the banks to turn those excessive reserves into new loans.  

There is more speculation that Switzerland will try to ratchet the franc lower by raising its target for euro-franc to CHF1.25 from CHF1.20.  While possible, I am skeptical.  First, why should it jeopardize the success it has already achieved for a couple more percentage points?  Second, the conservative nature of the SNB suggests they will wait to see the impact on money supply, credit growth and mortgage lending before taking more action.   The July data was released earlier today and while money supply picked up, mortgage lending and credit growth did not.  But more important than the July data will be the Aug and Sept data.  Still from the SNB point of view, the rumors do not need to be denied.  The rumors gives Swiss officials some breathing space and it means too that its balance sheet may not be increasing as much as some had feared insofar as the market can do more of the heavy lifting.  

The noises coming from the euro zone make it seem increasingly likely that Greece will get the next tranche of aid, but not clear resolution and the collapse of the Slovenia government yesterday poses new element of delay into the approval of the EFSF reforms.  The euro appears to be confined to a $1.3580-$1.3750 trading range and the break of that range could very well point the direction of the next 2-3 cent move.