Saturday, October 30, 2010

FX: Hell Week - 5 ½ days of endurance

Midterm elections, FOMC, ECB, BoE, BoJ & nonfarm payrolls
For a Navy Seal the defining event of BUD/S training is the 5 ½ days of brutal, cold, wet and near sleepless training known as ‘hell week’. While in a different universe altogether, the coming week will nonetheless prove enduring for the risk-averse investor - with US mid-term elections (Tuesday), FOMC meeting (Wednesday), ECB and BoE meeting (Thursday), and BoJ meeting and US non-farm payrolls (Friday). Add to this the fact that both the FOMC and BoE could very well set the direction for monetary policy in the core economies for, at least, the coming quarters and you have a recipe for market volatility.

How much have QE2 expectations been scaled back?
The pivotal event will undoubtedly be the FOMC meeting, where the question is still not whether the Fed will announce a second round of asset purchases (clearly it will), but rather what framework will be used this time around; a ‘big splash’ purchase or ‘small drip’ buying, as some have dubbed the alternatives.

A month and a half ago - when the market truly began pricing QE2 - the consensus expectation appeared to be for a ‘big splash’; i.e. the announcement of a large treasury purchase programme at the November meeting. Unsurprisingly, the dollar weakened in the weeks that followed, while at the same time risky assets and bonds rallied. However, events such as: (i) WSJ articles indicating purchases of a just few hundred billons, (ii) a strong UK Q3 GDP report reducing the likelihood of renewed Gilt purchases by the BoE,
and (iii) a questionnaire apparently sent to market participants by the Fed asking about expected buying (but limiting the highest answer to be a cumulated USD1,000bn over six months) are likely to have seen the market scale back QE2 expectations. This is at least what the past weeks’ rise in treasury yields and dollar rebound indicate. Hence, the risk of the Fed ‘disappointing’ - by announcing less QE2 than expected - appears to be lower now than it was a few weeks ago; as also illustrated by three out of seven analysts
surveyed by Reuters indicating that they do not expect QE2 to bring down the 10-year
treasury yield.

Confirmation of QE2 to trigger renewed dollar weakness
While the range of possible outcomes at Wednesday’s meeting is large, we expect the dollar to weaken on the majority of these. That is, we expect the knee-jerk reaction as the Fed announces its second round of quantitative easing to be that of lower yields, higher stock prices, and a higher EUR/USD. With QE2 expectations having been scaled back, we suspect that it will take a quite small asset purchase programme to trigger a dollar rebound – though of course with the market being very short the dollar, such a rebound
could be violent, and hence a tail-risk that one needs to factor in. Should the dollar rebound on Wednesday we would consider it attractive levels to hedge dollar income, not least since the ECB meeting on Thursday is likely to see Trichet maintain a relative hawkish stance - emphasizing the current divide between the ECB and the Fed.

A weaker dollar would also likely see weaker Sterling, though there are reasons other than the outlook of Fed easing to expect a higher EUR/GBP. That is, our UK economist sees a good probability that the BoE will launch its own QE2 programme on Thursday, which - as it opposed to the Fed’s is not expected in the market - could trigger a quite strong Sterling sell-off.

Full report: FX: Hell Week - 5 ½ days of endurance

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