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Fed QE2 Is Far from a Done Deal
09/27/2010 1:41 pm EST
The Fed took another baby-step toward further unconventional easing, formally indicating it would provide additional accommodation to support the economic recovery if necessary. Previously, only comments by Fed Chair Bernanke had signaled such actions. The Federal Open Market Committee (FOMC) statement also noted low inflation levels and hinted at policy actions to restore inflation to normal levels over time. Markets reacted as though the Fed had actually changed policy, as opposed to sending signals, but the moves appear to have some force: the USD weakened, gold soared, stocks rallied, and Treasury yields dropped around 20 basis points (bps).
We think it's important to note that the Fed statement does not mean that additional easing is necessarily forthcoming. For one, the US recovery will need to see further deterioration before the debate can be settled and additional easing agreed upon. In contrast, the most recent US data (e.g. housing and durable goods orders) suggests some stabilization after the weakness seen during the summer. Secondly, additional Fed action is unlikely before the November 3rd meeting, suggesting some of the recent moves may have been premature and/or excessive. Indeed, ten-year US Treasury yields recovered half of the post-Fed decline by the end of the week. Thirdly, additional unconventional easing takes the Fed into largely uncharted territory, not to mention effectively using up the last of the Fed's policy tools. Lastly, and perhaps most importantly, is that there are no guarantees additional easing from the Fed will actually succeed in boosting the US economy. High unemployment and weak final demand seem unlikely to be affected by lower interest rates, assuming any Fed actions actually result in lower market rates. We think the state of and prospects for the US recovery will need to be far worse than currently the case, not just to convince FOMC members that more action is warranted, but to leave them no alternative to taking the plunge. In short, the market reaction to the Fed shift may be excessive in the short-run, and we will be closely following US Treasury yields for any rebounds to pre-FOMC levels as evidence of that.
Is it Lose-Lose for the USD?
The USD reaction to the Fed shift in language was unambiguously negative, as US rates dropped and markets dumped the greenback on the prospect of additional easing measures. EUR/USD blew through the 1.3150/60 level we highlighted last week, surpassed the prior 1.3330 highs and effectively tested the 1.3500 level. At the same time, risk assets also responded positively, with stocks, commodities, and JPY-crosses all moving higher, further diminishing the USD's appeal. It would seem, then, that we're left with an environment where bad US news is met by further USD selling as the likelihood of additional Fed easing increases, and good US news is similarly met by USD selling as risk assets are bought. Such a lose-lose, Catch 22 situation is inherently unstable, but can also be the recipe for a sustained trend lower in the USD. Another recent driver of EUR/USD gains in recent weeks has been widening two-year rate spreads in favor of German bunds and against US notes (hence higher EUR/USD). That spread peaked this past Tuesday at -38 bps and finished out the week at -28 points, suggesting one source of EUR/USD strength may be diminishing. See below for further discussion of EUR frailties.
Next week sees month-end and quarter-end, and along with the usual volatility we think there is additional potential for USD selling, as asset managers sell more USD to rebalance hedges after monthly and quarterly gains in US stock indexes. But similar gains in non-US indexes may offset this USD-selling to some degree, so it's not clear-cut. Also, we have reached some important technical levels that bear watching. The 1.3510/20 level in EUR/USD is the 50% retracement of the Nov. 2009 highs-June 2010 lows. The US dollar index is also sitting on key support at the bottom of the weekly Ichimoku cloud at 79.33. If those levels were to break, we would reckon with further USD weakness overall, and another surge higher in EUR/USD, likely to the 1.3750/3800 area next. Immediate support for the move higher in EUR/USD is now at 1.3300/50, where a drop below may signal the start of a potential reversal.
Precious metals shine
Gold marched to new record levels this week, reaching highs around $1300 an ounce. The yellow metal closed at record highs for five consecutive sessions as expectations that central bank action will erode the value of currencies resulted in investors seeking safety elsewhere. The Fed said in its FOMC statement on Tuesday that it “is prepared to provide additional accommodation if needed”. Many viewed this as a hint towards another round of quantitative easing. The precious metals benefited as the dollar weakened significantly amid the speculation of more asset purchases by the Fed. Gold prices tend to move inversely to the US dollar so it is not surprising to see demand for gold increase as investors sell the buck.
Moreover, the risk to holding major currencies has driven the market toward the metals. Sovereign debt issues are still lurking in Europe’s fragile economy, the BOE joined the Fed this week in considering additional stimulus, and anticipation of another wave of BOJ intervention make gold and silver look more attractive.
Silver did not go unnoticed as it surpassed the March 2008 highs of roughly $21.35 to reach levels that have not been seen in 30 years. Silver has outpaced gold so far this year, gaining about 26% while gold is up about 18%. With interest rates at low levels and risks to holding currencies as central banks move closer to providing additional stimulus, traders are looking towards the metals for returns.
While we think the current trend higher will continue, we would be cautious to establish longs at current levels. XAU/USD is just under rising channel resistance which is currently around the 1300/02 level. Rising channel support is parallel to the resistance and comes in around 1265. The prices have been contained within this bullish channel since the end of July. Some key levels within the channel are the 23.6% retracement level around 1285 and the 1270/72 pivot. A move below the channel support and 61.8% Fibonacci retracement around 1260 is likely to see a deeper correction towards 1240 and a break above the channel resistance with a move above 1310 may see gains extend.
Stronger euro out of synch with fundamentals
Europe’s economic fundamentals might be deteriorating, but that hasn’t been enough to stop the euro in its tracks. The plunge in the Eurozone’s composite PMI sentiment survey for September, down to 53.8 from 56.2 in August, was the strongest signal yet that the economic recovery is losing momentum. Yet the euro is still trading at five-month highs.
So what is fueling the single currency? Rather than ditch the euro, investors instead are targeting the problem peripheral economies directly. Investors demanded a higher risk premium to buy Irish and Portuguese government debt at auctions this week, pushing up their funding costs just as growth appears to be stalling. The cost to insure against an Irish default rose to EUR463,000 for EUR10m exposure, according to five-year credit-default swap prices, after it was announced that the Irish economy returned to recession in the second quarter. This compares with the core economies that are still fairly resilient; for example, Germany’s IFO business climate sentiment index rose to a 3-year high in September.
Government bond yields in Spain also came under pressure prior to finance minister Elena Salgado announcing the 2011 budget this afternoon. Yields eased by the end of the European session as markets cheered Spain’s tough austerity program for next year. Some commentators have noted that the worst is already priced in for Europe’s peripheral economies, most notably Ireland. Yet if governments don’t fulfill their plans to cut deficits then the markets may punish them once more.
Euro strength is also a function of dollar weakness. Investors have turned bearish on the greenback as speculation mounts that the Fed will increase the monetary base to stimulate the US’s lackluster economic recovery. In comparison, the ECB have not signaled another round of monetary stimulus, although they are buying government bonds as a way to reduce pressure on the peripheral economies’ bond spreads.
The rally in the euro is a fragile one for two reasons. Firstly, if growth is slowing in Europe then the interest rate differential between the US and Europe—currently in the euro’s favour, will start to reverse. Secondly, the frequency of euro zone debt problems spooking the market is increasing. If this continues then we expect to see sentiment toward the euro to begin to erode.
Softening data and the latest MPC Minutes release suggests further easing ahead
Last week’s stream of negative data continued this week providing evidence of a stalling recovery in the United Kingdom. Monday saw the release of August Mortgage Approvals print a disappointing 45k vs. expected 46k and a prior 47k in July. Thursday’s release of the August BBA Loans for House Purchase did nothing to allay fears of a stagnating UK housing market as it too disappointed with a 31767 print against expectations of 34000. The trend in data deterioration has not been confined to the housing market, sour remnants from last week’s August Jobless Claims Change (increased to 2.3k vs. an expected -3k decline) and August Retail Sales ex Auto MoM (-.4% vs. expected +0.2%) suggest an economy facing significant headwinds to growth prospects. Continued moderation in UK data may deem economic resuscitation a necessity in the near future. The latest release of the MPC Minutes suggests the Bank of England would be ready to meet such a need: ‘The Committee considered arguments in favor of a further easing in the stance of monetary policy’.
A marked deterioration in the domestic and global growth outlook, which we believe to be a likely possibility, may push the Committee’s hand to take part in another round of QE; either in the form of gilt purchases or credit easing via direct buying of private sector assets from the market. The timing of further easing will be dependent on the rate of data degradation in the weeks ahead. Next week’s final 2Q GDP release is likely to be in line with expectations of 1.2% for the quarter and 1.7% for the year. The MPC tends to regard survey data as an effective indicator of current economic health and is likely to focus on upcoming manufacturing and service sector releases to determine whether QE2 will be undertaken sooner (November) or later (Q1 2011). With impending budget cuts scheduled in October, our view is that further stimulus is more likely to occur later, after the impacts of budget tightening are fully assessed. Key technical levels to watch in the week ahead are the psychologically significant 1.6000/50 resistance zone (38.2% retracement for the 7/08 to 1/09 primary decline) and the psychologically significant 1.5500/25 support zone (April to late July highs). The underpinnings of a struggling economy suggest weakness may be in store for the cable and we believe any strength towards the aforementioned resistance level may present an opportunity to take advantage of a medium-term correction lower.
Key data and events to watch this week
US data starts off on Monday with the August Chicago Fed National Activity index and the Dallas Fed manufacturing outlook survey for September. Tuesday sees the July S&P/Case Shiller Home Price index, September consumer confidence, and the September Richmond Fed manufacturing index. The Fed’s Lockhart speaks on Tuesday while the Fed’s Plosser and Rosengren speak on Wednesday. Thursday sees 2Q final GDP, weekly jobless claims, and the September Chicago PMI. Friday rounds out the week with August personal income and spending, PCE, ISM manufacturing, and final Sept. Michigan confidence.
The euro zone kicks off the week on Monday with speeches by ECB Pres. Trichet and VP Constancio. German October GfK confidence and September preliminary CPI will be released on Tuesday. Wednesday sees the September EZ business climate indicator and EC confidence figures, along with the monthly meeting of EU Fin. Mins. Thursday sees France’s August PPI, Germany’s September employment data, and the EZ CPI estimate for September. Friday finishes the week off with German retail sales for August, final September manufacturing PMI's and the EZ unemployment rate for August.
The UK economic data begins with Monday’s Hometrack housing survey for September. Tuesday sees a speech by the BOE’s Posen and 2Q final GDP, current account, and total business investment. Wednesday sees August net consumer and mortgage lending and the September GfK Consumer confidence survey. Thursday includes a speech by the BOE's Tucker as well as Nationwide House prices for September and Friday wraps up the week with September manufacturing PMI.
Japan’s calendar starts off with a speech by BOJ Governor Shirakawa on Sunday. The BOJ Governor speaks again on Monday and August Merchandise Trade Balance data is also set for release. Due out on Tuesday is September small business confidence and Wednesday sees the Tankan Survey results for 3Q. Thursday sees August retail sales, housing starts, construction orders, and August preliminary industrial production. Friday finishes things off with August employment data, household spending, and national CPI.
Canada’s data begins on Wednesday with industrial product and raw materials prices for August. Thursday ends a short week of data with July GDP and a speech by BOC Governor Mark Carney.
The calendar down under starts on Wednesday with New Zealand’s August trade balance and Australia’s Conference Board Leading index. Thursday will see NZ building permits for August and the September NBNZ activity outlook and business confidence numbers. Also set for release on Thursday is Australian HIA new home sales, building approvals, and private sector credit all for the month of August. Friday finishes the week with the September RBA commodity index and September AiG Performance of Manufacturing index.
Be on the lookout for important China data as well. August industrial profits are due on Monday, the September HSBC manufacturing PMI is due on Wednesday, and September manufacturing PMI is set for release on Friday. Sometime between Sunday and Wednesday the August Leading index will be released.
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