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FOMC's stunning announcement yesterday that it will buy up to $300 Billion in Treasury bonds took the currency market by surprise and rallied the EUR/USD by more than 500 points in less than 24 hours. As we  wrote earlier the FOMC announcement ,” represents an 'all-in' bet on massive monetary stimulus in order to stem the worst contraction in the US economy since World War II. The move is of course wildly dilutive to the currency with nearly $1 Trillion created out of thin air. Little wonder then why the dollar collapsed across the board even as other asset classes rallied. It also indicates that the Fed may have come to the conclusion that the two biggest customers for US debt – China and Japan – may be unable or unwilling to provide additional capital to finance the gargantuan expansion of US fiscal spending this year and next.”

The later point is worth exploring further, as we believe that it was the key catalyst for Fed’s sudden plunge into full scale quantitative easing.  For the past few days we have been warning that the markets were far too complacent about the rapid deterioration in US capital flows.  The TICS report which was released on Monday, showed a  sizable deficit for the third month out of the past four. To put that data into perspective  we need to note that up to October of last year,  capital inflows were positive every single month since Treasury Department  began collecting the data in 2003.

Fearing that US may not be able to attract enough foreign capital to finance the ambitious fiscal spending plans put in place, the Fed effectively made itself the buyer of last resort  for US Treasuries.  So far the gambit has worked with yields on the 10 year bonds dropping by nearly 50 basis points in one day.   If the Fed can maintain US bonds yields at the current low levels,  it would succeed in minimizing the cost of financing the massive US fiscal deficits and more importantly will be able to monetize most of the toxic debt in the US financial system without triggering serious inflation.

The key to the success of quantitative easing however will rest with Main Street rather than Wall Street. If  the Fed’s move helps to stem the worst US economic contraction since WWII and more importantly if it helps mitigate further job losses, foreign capital will not abandon the dollar, as traders will buy US assets in anticipation of an early recovery.  Yesterday’s massive jump in the EUR/USD will only serve to aggravate the export dependent EZ economy and therefore any rebound in growth is likely to come from US first.  However, if these stimulative policy moves fail to revive the economy the EUR/USD will continue it ascent irrespective of EZ fundamentals. As we wrote earlier today, “only time will tell if the Fed’s  strategy succeeds or simply debases the dollar further, “ but in the meantime “the EUR/USD is now trading on strong speculative momentum and if yesterday’s policy change prompts a panicky liquidation of dollar assets, the pair could have more upside left"

 

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About The Author

Boris Schlossberg began his Wall Street trading career more than 20 years ago at Drexel Burhnam Lambert. There, he traded nearly every type of financial product on the market in the U.S., from equities and options to stock index futures and foreign exchange. His innate ability to analyze market information and use it to trade has helped him become an industry-recognized, “go to” trading professional.

These days, whenever the markets move, many organizations turn to Schlossberg for his take on the situation. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of Technical Analysis of the Currency Market and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Kathy Lien. He joined GFT in 2008.