Forex Trading in the Post-QE2 Era

07/04/2011 8:00 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The official end of QE2 doesn't signal the Federal Reserve's all-out exit from the markets, but a potentially stronger US dollar and ongoing euro volatility will be the important forex themes to watch.

The headlines in the financial markets are focused on Greece, but the big story is the end of the Fed's latest quantitative easing program (QE2). To no one's surprise, QE2 is passing quietly into the night because the central bank's plan to reinvest principal payments on maturing securities means they are not going to be disappearing from the markets completely. 

Over the next 12 months, the Fed is expected to purchase as much as $300 billion worth of Treasuries, and in doing so, they will be keeping the level of stimulus in place and avoiding the panic that would be caused by a major selloff in the Treasury market.

Back in November 2010, the Federal Reserve announced a plan to buy $600 billion in long-term Treasuries in an operation that was set to last for eight months. This program was aimed at stimulating the economy by keeping interest rates low. Having dropped the Federal Funds rate to a record low in December 2008, the central bank resorted to buying Treasuries to drive rates even lower.

The first round of quantitative easing ended in April 2010, but the program failed to effectively stimulate the economy, forcing the central bank to announce another round of asset purchases.  

Taking a look at the current performance of the US economy, some will argue that more stimulus is needed, but given the degree of criticism that the Fed received for implementing quantitative easing to begin with, and the skepticism that has surfaced about the success of QE1 and QE2, the chance of a QE3 is slim; especially now that a crisis has been averted with Greece voting "yes" to more austerity measures. 

Post-QE2 Trades

Given that the Fed will continue to stimulate the economy by keeping interest rates low and reinvesting payments on maturing securities, it would have been foolish to expect a vertical move higher in the US dollar on Friday (July 1).

Instead we expect the greenback to trickle higher as the end of QE drives up yields and puts the central bank one step closer to raising interest rates. Although we do not expect the Fed to raise rates until the middle of next year, once the economy strengthens, they will start to talk about tighter monetary policy, which will help the US dollar.

USD/CHF should benefit the most as safe-haven flows ease out of the Swissie. We have already seen USD/CHF move sharply higher, and if the Europeans get their debt crisis under control, money should flow out of the Swiss franc and into other currencies.

USD/JPY should benefit from the end of QE2 as well, while the prospects of additional volatility in the EUR/USD caused by unresolved issues makes it a less-attractive trade.

Last week’s US economic reports were mixed with jobless claims falling only 1k last week--less than expected. However, manufacturing activity in the Chicago region accelerated last month, which is a breath of fresh air after the slowdown seen in the NY and Philadelphia regions. Even though prices, employment, order backlogs, and inventories declined, the rise in production, new orders, and supplier deliveries reflect strength in the Chicago manufacturing sector.

The Greek Parliament has begun to vote on the implementation procedures for their austerity plan, and we do not anticipate any major hiccups. German finance minister Schaeuble also announced that they have reached an agreement with German banks to roll over Greek debt, ensuring continued financing for Greece and hopefully avoiding a default.

By Kathy Lien of KathyLien.com

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