Whether it comes in the form of an outright increase in asset purchases (QE3) or a shift in the composition of its current balance sheet, the Federal Open Market Committee’s policy meeting this week is expected to hold the reins for direction and volatility for the US dollar going forward. This incident promises a definitive outcome for investors to deliver temporary relief in moral hazard. This event could possibly determine the medium term trend for the greenback.
The first thing we need to consider is why the market believes the Fed is even thinking about another round to boost confidence, the economy and markets. After the $600 billion, QE2 program matured by the end of Q3, it was clear that the total impact on the market would fall far short of what officials had likely hoped for. Rather than encouraging capital markets to rise in the afterglow of the massive program, the S&P 500 quickly stalled and then went into a steep correction at the end of July. With the world facing a global slowdown and growing financial problems, the uneasy stability we have found this month is almost certainly heavily rooted in expectations for further stimulus from the Fed.
That brings us to the scenarios that the market sees for the Fed. The most probable outcome is that after the two day meeting, Fed Chairman Bernanke will announce changes to the composition of the balance sheet. This is the option that many equate to ‘Operation Twist’ – a program implemented in the 1960’s aimed at flattening the yield curve (or in layman’s terms, to reduce the longer dated interest rates). Considering lower rates on short term loans is more relevant for banks and lower rates further out is more appropriate for consumers. This scenario would be more tailored to driving growth. It is very likely that the broader market believes this effort is already done. Therefore, we can assume that a lot of its good will influence is already priced in. Also, a problem is that this program does not materially improve the short term liquidity situation. As the European crisis develops, a bank crunch may lead to huge problems up and down the yield curve.
For a more hawkish alternative, the Fed could announce an outright purchasing program to supplement its current holdings. This would be called a QE3 move. It would most likely lead to an immediate surge in capital markets and a sharp tumble for the dollar. This does not come as a sign of confidence in the capital markets. It is more likely as an effort to get in front of the Fed’s buying to take advantage of the appreciation. It is also likely that regular market participants would reverse their positions immediately after the central bank finished or before.
Finally, we have the bearish scenario: the FED announces that it will let the market take its natural course and will not further intervene. If this is Fed’s course, expect capital markets to sell off immediately and the US dollar to find strength in a demand for liquidity.
Posted by David Frank, Avafx