The Curious Case of Benjamin Bernanke and QE3

BBH CurrencyView

• Market action is quiet ahead of today’s Jackson Hole speech; US Q2 GDP likely to confirm slowdown
• We do not expect an announcement of next round of asset purchases; yet doubt Fed will limit tools
• EM asset prices are likely to continue trading as high beta irrespective of Bernanke’s speech

Ahead of today’s Jackson Hole speech markets appear quiet, with the dollar trading soft against most of the G10 currencies, while US futures indicate a positive open. With the European data calendar having limited impact on price action, the euro remains confined to its recent range, marking time near $1.444. U.K. Q2 GDP, as expected, was confirmed at 0.2% q/q and 0.7% y/y, which encouraged some tentative repositioning by sterling shorts, but overall left sterling little changed from yesterday. Elsewhere, Meanwhile, Swissy weakened after the KOF Leading Indicator plunged and raised local market speculation of more SNB measures to counter franc strength, while the Australian dollar rebounded, up 0.7%, after the RBA downplayed rate cut expectations. European stocks continue to remain under pressure with the DAX down nearly 2% driven in part by concerns of a potential downgrade and the likely short-selling ban that was extended in France, Italy and Spain.

The market focus in the North American session today is most certainly going to be Bernanke’s Jackson Hole speech. In turn recent price action suggests that markets are bracing for some sort of policy put that would go some ways to supporting financial conditions and provide the US economy with a much needed boost. And while we do not expect the Chairman to announce another round of asset purchases just yet (though some observers wonder the efficacy another round of purchases would have on economic growth going forward), we doubt that the Federal Reserve is likely to sit by idly as the US economy moves toward “stall speed.” Instead, against this backdrop we suspect that the Fed is likely to outline a range of potential policy actions that may include the extension of the Fed’s treasury holding maturities, a potential cut in the excess reserves held by member banks at the Fed and changing the composition of the its balance sheet through MBS purchases and Treasury sales. At the same time, the Fed is also likely to maintain that while the growth outlook for the economy continues to slow; it is likely to reinforce its view that the growth outlook going forward remains constructive against the backdrop of falling oil prices, supportive growth in EMs and strong recovery in Japan. In short, it is hard to determine the expected market response but nevertheless the market risks for FX are asymmetric. Ahead of the speech FX markets appear to taking a risk-on approach, which suggests the potential for a positive market reaction to the speech. In this scenario, we suspect that the dollar would most likely come under broad selling pressure but would caution against establishing new longs against the euro. Rather, based on current positioning and sentiment trends the AUD and NZD would be the two currencies likely to advance in a positive response followed by CAD, which according to recent trends in positioning data has experienced less selling pressure than the antipodeans. Meanwhile, a negative market response would likely increase demand for the perceived safe havens, with the dollar likely to benefit the most against the aforementioned growth-sensitive currencies – given the asymmetric risks of further SNB and BoJ intervention to stem currency strength which may limit immediate speculative flows into the JPY and CHF. The EUR is unlikely to break recent range, which makes it a sell ahead of $1.45 and attractive near $1.40.

EM asset prices are likely to continue trading as high beta irrespective of the outcome of Bernanke’s speech today.Still, there are a few important points to keep in mind in terms of relative performance. In the event of a positive outcome from the Chairman’s speech, we expect MXN to gain back some grown against BRL. MXN is down about 2% vs. BRL on the month and 8% since May given the focus on the downside risks to US growth. Indeed, demand protection against MXN downside seen through risk-reversals has now surpassed that for BRL. This rare event has occurred before, but never lasted more than a few sessions. We think that both the moves in spot and in options may have been overdone in relative terms. If the outcome turns out to be negative for markets, we expect KRW and INR to underperform the region and IDR and especially SGD to outperform given its safe-haven status. In EMEA, TRY and ZAR should come under pressure the most during a selloff. Should CHF once again appreciate sharply in this scenario, PLN and HUF will again come into focus given the lingering issues with FX-linked debt. Another important factor to watch will the reaction in energy prices. We think RUB will likely be the biggest beneficiary if today’s event lead to a solid bid in energy markets.