Fed Action Spurs Risk Appetite

Highlights

The US dollar continues to trade heavily in the aftermath of the FOMC statement that underscored the Federal Reserve’s readiness to move. Although activity has been choppy the direction is clear. The euro joined the other major currencies by moving above its 200-day moving average yesterday. Follow through buying today has lifted the euro through its August highs. Even the yen, where intervention fears had kept the buying in check has strengthen and is at its best levels against the dollar since the actual intervention took place (~JPY84.50). The price action indicates this is a dollar move not a yen move (as the yen is softer on most crosses), and with Japanese markets closed tomorrow, another bout of unilateral intervention looks unlikely, giving yen buyers a bit of encouragement today. Most of the emerging market currencies are participating in the move against the dollar as well, though market talk suggests a couple central banks in Asia may have tried to slow their currencies appreciation.

While the markets in South Korea, China and Taiwan were closed the stocks in other Asian countries rose. The MSCI Asia Pacific climbed to 125.53 by 0.54%, which is the highest level since April 30^th. Equities rose as the Fed’s willingness to inject additional liquidity into the financial system become increasingly likely after yesterdays comment. In fact, money continues to flow into Asia and Australia as growth is expected to continue. On the other hand, European stocks retreated for a second day amid concerns that central banks will have to act to shore up flogging growth. The Euro Stoxx 50 Index is down nearly 1% with consumer service industry down nearly 1.6%, weighed by concerns of the weak economic data. Overall, the growth divergences in Asia and Europe has led to a split trading session where Asia seems poised to benefit the most from Fed liquidity.

In Europe, the Portuguese government debt agency IGCP said it sold €450 million of bonds due in 2014 and €300 million of bonds due in 2020. On the whole most Europeans yields dropped with the Greece and German two year dropping by 13 and3 basis points. Although the yield on 2 year Irish and Portuguese were up by 37 and 14 basis points. In addition, the Bank of England (BOE) signaled policy makers are moving closer to adding more stimulus to the economy, joining the Fed in contemplating further bond purchases. On the back of the news the yield on the 2 and 10 year, Gilts were down marginally. And finally, US treasury yields were down on the day with the spread to German yields widening in the euro’s favor.

Currency Markets

Several forces had begun working against the US dollar over the past couple of weeks. Our work has tended to emphasize the sifting interest rate differentials, market positioning and technical factors. The FOMC statement further pushes the market in the direction it was already headed. The market’s response to the FOMC statement, taking 10-year Treasury yields down 13 bp with more follow through today, and new record low 2-year yield, seems as if the Fed announced that it was indeed embarking on what has been dubbed QEII. Indeed a Reuters poll of primary dealers found 10 of 16 expect the Fed to buy more Treasuries compared with 9 of 16 at the start of the month. Seven see the Fed beginning as early as Nov. The Fed’s heightened concern about deflation (the undershooting of inflation) probably has received the most attention.

Outside of the boilerplate reference to the high levels of unemployment, the Fed did not mention the difficultly addressing this part of its mandate. On one hand this may take some of the focus off of the “significant deterioration” bar for additional easing and the market’s focus on the US labor market and shift it toward the inflation and inflation expectation reports. However, many readings of inflation and inflation expectations do not appear all that worrisome. The core PCE deflator stood at 1.4% year-over-year in July. The Fed’s informal target is thought to be 1.70%-2.0%. The 5-year/5-year forward that the Fed has cited in the past as measure of inflation expectations it looks at has risen from about 1.85% in late August to almost 2.5% as of Monday, the eve of the FOMC meeting. The breakeven of 10-year TIPS is about 1.86%, up from about 1.46% in late August. The 5-year break-even has been more subdued. It bottomed in late August near 1.10% and stands just above 1.21% now.

Of course, there is a feedback loop and market expectations are not set independent of policy action. In effect the rise in inflation expectations has taken place alongside expectations of new Fed measures. If the market is behaving as it the Fed has already begun QEII, perhaps with its $28 bln purchases of Treasuries since late August as it recycles the proceeds from its mortgage holdings. From the consensus point of view there are three questions: how large of a program, when will it begin and how effective will it be. Tentative consensus answers appear to be incremental size, with most expectations seeming to fall between $500 bln and $1. Trillion that can be announced as early as the next FOMC meeting, the day after the Nov mid-term elections, and most did not seem to think it will be particularly effective.

In addition to the Fed, the BOJ and the BOE may also be moving to additional measures. What still appears to be unsterilized intervention by the BOJ is thought to be followed in early October by some additional measures. The minutes of the BOE recognized that it too might have to provide more support, even though, like at the Fed, there is a single dissenter. Given the current account positions, new QE may weigh on sterling more than the yen. Meanwhile, the market has begun probing the BOJ’s resolve. Investors should be prepared for additional dollar decline in the coming weeks. Much of the euro’s advance has thus far appears to be short-covering. AS of last week, the net speculative position at the IMM was still short the euro. There is scope for that market to accumulate a long position and given the interest rate differentials, have the greatest incentive to do so this year. The euro has moved above its 200-day moving average for the first time since January (~$1.3215). The Swiss franc did so back in mid-July and sterling traded with its 200-day moving in late July and Aug, but was back below it earlier this month. More recently it has broken back convincingly above it (~$1.5365). One of the technical signals that helped boost our confidence of the dollar’s rally earlier this year was that the 50- and 200-day moving averages had crossed in a negative for these currencies. These averages have now crossed in a positive direction for the Swiss franc (mid-August) and sterling (early Sept). The euro’s averages have not crossed yet, but will likely do so before the end of the month.

Upcoming Economic Releases

The US House Price Index m/m will be reported for the month of July. Consensus suggests a slight decline from 0.3 to 0.2. And finally, in Canada the m/m Leading Indicators and Retails Sales will be reported at 08:30 EST / 12:30 GMT. The consensus is sharp increase in both indices.