Fed, ECB Inaction Keeps FX Risk High

08/29/2011 10:23 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Risk remains high after last week’s Fed summit did not result in the announcement of new stimulus measures. Eurozone banking stresses and the upcoming US Labor Day holiday are also key factors for currency traders.

As we suggested last week, Fed Chairman Bernanke failed to deliver any new measures to support the economy and instead voiced optimism that the pace of recovery would still improve into the end of the year. We find it difficult to share his optimism, but markets thought otherwise and turned disappointment into a surprising rebound in stocks and commodities.

All in all, however, major markets remain in consolidation mode after the large selloff earlier in the month. Heading into the last week of August, we still think raisk assets remain vulnerable, and we will be watching for a resolution (breakout) of the current consolidation range, especially around the US Labor Day holiday on Monday, September. 5.

Grasping at Straws on QE3

Some analysts have suggested that the resilience in risk assets is due to Bernanke hinting that additional Fed policy measures—including QE3—could still be adopted. He pointed to the September 20 Federal Open Markets Committee (FOMC) meeting as being lengthened and that all policy options would be discussed.

If so, markets may be grasping at straws, hoping that another round of asset purchases will somehow revitalize the economic outlook, even though QE2 seems to have done little for the real economy apart from spawning a nice rally in stocks. By the way, that rally has now retraced by 76.4% since the April highs.

Markets may also be reacting to the notion that Bernanke did not warn of a potential double-dip recession, encouraging investors to think better of the outlook. However, we think the headwinds in the US are gathering force rather than waning.

With the Fed increasingly ineffectual, that leaves Congress as the sole source of any fresh stimulus. And given the political gridlock in Congress, we are not optimistic over any new initiatives coming out of Washington anytime soon. Perhaps President Obama may generate some optimism when he unveils his jobs plan after Labor Day, but if any of it requires Congressional action, such as extending the payroll tax break, we would expect it to fail, leaving the economic outlook continuing to twist in the wind.

As for the outlook for this week, we would expect further consolidation in major stock indexes and for the US dollar (USD) to trade in recent well-worn ranges. Month-end volatility could see a break of recent ranges, and at the moment, it looks to be to the USD downside. But we think it may only be a false break given global market uncertainties, and we would revert to selling risk assets on rallies.

This Friday will see the US August employment report, with a sample coming on Wednesday from ADP, but current forecasts do not signal any material improvement in job creation is at hand.

NEXT: Eurozone Financial Stresses Continue to Appear

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Eurozone Financial Stresses Continue to Appear

Overnight, USD lending rates continue to creep higher, suggesting that funding stresses remain within the Eurozone banking sector. The overnight rates are nowhere near crisis levels, but this bears watching, as we have repeatedly seen credit confidence plunge on short notice.

We would note that credit spreads between the core and periphery have started widening again, and sovereign credit default swaps have resumed edging higher, all indicating heightened credit tensions.

September will see Eurozone parliaments working to pass the laws necessary to implement the changes in the European Financial Stabilization Facility (EFSF) agreed to at the July 21 summit, and most are expected to do so by the third week.

After the EFSF is up and running, we will be watching closely to see if the European Central Bank (ECB) continues to buy Spanish and Italian government debt. If they do, we would expect financial market conditions to improve, as the ECB has virtually unlimited balance sheet resources.

If the ECB steps back, we would expect markets to shudder—potentially seriously—as the EFSF has limited firepower, especially when it comes to Spain and Italy.

By Brian Dolan, chief currency strategist, FOREX.com

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