U.S. dollar and Fed QE2 – the morning after

Major Currencies vs. US Dollar (% change)

01 Nov 2010 – 05 Nov 2010

CHART 1

General Comment: US Dollar and Fed QE – The Morning After

The hangover after last week’s dizzying surge in risk appetite has descended upon the markets, with the US Dollar rallying decisively against most major currencies having reached multi-year lows after the Federal Reserve rebooted its quantitative easing (QE) program. The key question now is whether current price action represents little more than a near-term correction or something bigger and more significant. Indeed, one can’t help but wonder if the sudden parade of QE skeptics across the wires – a group notably including three Fed officials, two of whom voted for its reinstatement – is starting to breed doubts about the policy’s merits or, worse yet, rekindling fears of competitive devaluation.

Regardless, a deeper US Dollar rebound seems likely going forward considering that even in the more modest correction scenario, the move to be retraced dates back not to last week but to August when the Fed began to publicly massage the idea of renewed stimulus at the central bank summit in Jackson Hole. Having deftly managed the markets’ expectations over the subsequent months, Ben Bernanke and company delivered just about what the markets had priced in, removing a good bit of uncertainty and opening the door profit-taking ahead of the year-end.

As for the threat of “currency war”, traders will be tuned in with bated breath for the outcome of the G20 leaders’ summit in Seoul this week, although expectations of some sort of paradigm-changing “grand bargain” seem remote. The most likely outcome is for a final communiqué thin on specifics but packed with vague commitments not to engage in competitive devaluation, which may boost risk appetite temporarily but ought not prove lasting considering it would amount to little more than a restatement of the status quo.

EURUSD: Euro Threatened as Risk Trends Shift Into Reverse

The Euro continues to track broad trends in risk appetite with prices still showing a strong correlation with the MSCI World Stock Index on 20-day percent change studies. Needless to say, this directly threatens the single currency as risky assets correct lower. However, the pair may find support in preliminary Eurozone Gross Domestic Product figures expected to put the annualized growth rate at 1.9 percent in the third quarter, matching the two-year high set in the three months through June, as well as the expiry of a 6-month ECB LTRO that may put upward pressure on yields.

CHART 2

Source: Bloomberg

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