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FOMC Preview: Why More QE May Not be so Bad for the Dollar

Last updated 9/20/2011 12:47 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

By Kathy Lien, Director of Currency Research at GFT

The general belief in the market is that more Quantitative Easing or stimulus is bearish for the U.S. dollar because it lowers U.S. yields and erodes the value of the greenback.  Although this may be true in the long term, in the short term, the dollar could respond positively to more QE.  With only 24 hours to go before the FOMC announcement, investors around the world are sitting at the edge of their seats waiting for the Federal Reserve’s monetary policy decision. The sell-off in the U.S. dollar today and rally in equities suggests that investors are already squaring long dollar positions and laying on their pre-QE3 trades.  Having expanded this month’s meeting from one to two days, the central bank has set the market up for a big announcement.  Thanks to their advance notice, economists and investors have had plenty of time to consider what the Fed will do and the consensus view is that the central bank will opt for Operation Twist, a monetary policy tool used back in the 1960s.

Preparing the market for a big announcement has its pros and cons.  By pre-setting expectations, the Federal Reserve can minimize volatility but the downside is that they are also limiting any positive response.  At this point, if the Fed simply opts for selling short term Treasuries and using those funds to buy long term Treasures (the definition of Operation Twist), it may not be enough to rally currencies and equities.   The sheer disappointment of the Federal Reserve coming up short by simply meeting expectations could drive the dollar higher.  However underwhelming the market is not the only reason why the dollar could respond positively to more stimulus.  According to Figure 1, when the Fed announced the first round of Quantitative Easing in November 2008, the dollar sold off on the day of the announcement and then rallied for the next 4 trading days against the euro. The same price action occurred in November 2010 when the Fed announced its second round of QE (Figure 2).  The dollar sold off against the euro on the day of the announcement, extended its losses the day after, stabilized and then proceeded to rally aggressively for the next month. In other words, the dollar found a short term bottom against the euro shortly after the Fed announced QE2. Figures 3 and 4 show how QE2 was more positive for USD/JPY than QE1 but in both cases, the currency pair consolidated after the announcement before taking off.  The reason why the EUR/USD had a more pronounced reaction to QE than USD/JPY is because Europe and the U.S. have more divergent monetary policies than the U.S. and Japan.  The initial weakness in the U.S. dollar against the euro only lasted for the first 24 hours after QE1 and 2 were announced and it was not until months later before the greenback really started to tank.

Will the Federal Reserve Underwhelm or Overwhelm?

  For anyone hoping that Bernanke will ride in like a white knight carrying a cart load of stimulus, the risk of disappointment is greater than the risk of a surprise because even the central bank has warned that their ability to stimulate the economy is limited.  With the U.S. economy experiencing zero employment and retail sales growth in the month of August, desperate times call for desperate measures.   The Federal Reserve has been preparing the market for more stimulus in some form or another since the last FOMC meeting and in doing so, they have given investors an opportunity to discount a move, which means if they want a strong and positive reaction from the markets, they need to overwhelm and not underwhelm.  Operation Twist has been talked about extensively as the option the Fed will choose to stimulate the economy but the problem is that it has already been priced in by investors and may therefore elicit nothing more than a weak response, wasting the central bank’s efforts.  The same is true for lowering the interest rate on reserves.  Operation Twist underwhelm the market and may even trigger a buy the rumor sell the news type of reaction.  If the Fed wants to surprise the market and trigger a sharp rally in currencies and equities, they will need to be more aggressive which means combining different options and perhaps taking an even bolder step by tying interest rates to a piece of economic data like the unemployment rate, an idea suggested by Fed President Evans.

The Fed’s options include:

1) Doing nothing

2) Funding the purchase of long term Treasuries with the sale of short term ones (Operation Twist)

3) Lowering the interest rate on reserves

4) Announcing another round of asset purchases

5) Tying interest rates to economic data (like the unemployment rate)

Doing nothing would be the worse thing that the Federal Reserve could do and would most certainly send currencies and equities plunging.  The reasons why the central bank could do nothing are because inflation is high and every effort so far has failed to stimulate growth.   Unfortunately inaction is inexcusable because preventing recession is just as important as promoting growth and the U.S. economy stands the risk of falling back into recession without more support from the Fed. Just because no press conference has been scheduled does not preclude a major policy change.   Fielding questions from reporters and giving Bernanke an opportunity to shoot himself in the foot could end up being more counterproductive.  Operation Twist is the step that most investors and economists believe the central bank will take but the success of Operation Twist is also debatable.  It flattened the yield curve in the 1960s but only lowered long term Treasury yields by approximately 15bp, an amount that was highly statistically significant but moderate according to the San Francisco Federal Reserve.  A 15bp reduction in LT yields is often likened to a 1 percent rate cut but ultra low rates has done little to encourage corporate spending and hiring. Faced with a deep recession and a persistent international balance of payments deficit, the Kennedy Administration felt that Operation Twist would be a grand-sweeping solution for both problems.  By buying long term Treasuries and actively lowering long term yields, they hoped to encourage business investment and housing demand with lower long term yields and attract foreign investment demand with higher short term yields.  The difference between the 1960 version of Operation Twist and the 2011 version is that the program was only $8 Billion in the 1960s – Bernanke’s version will be much larger.  However if the Fed really wants to send a strong message to the market, they need to do more and a combination of different tools appears to be their best option.  Hopefully they will overwhelm and not just meet the market’s expectations.

Checking in on the U.S. Economy

The reason why the market is so dead set on more stimulus is because the recovery in the U.S. has come to a screeching halt and everyone including the Fed agrees that the economy desperately needs help.  The following table shows how the economy has performed since the last monetary policy meeting and we can see widespread deterioration.  Aside from zero consumer spending and employment growth, the housing market and manufacturing sector weakened.  The service sector improved slightly and inflation increased but along with the volatility in the financial markets, the central bank has more reason to be concerned than optimistic which is why they will be ignoring the price pressures and charging forward with more stimulus.

Figure 1

 Figure 2

Figure 3

Figure 4

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.