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FOMC Will Not Implement QE3, but Other Forms of Easing Possible

By , Currency Strategist
20 June 2012 15:50 GMT

For trade setups, please refer to Currency Strategist Michael Boutros’ and Currency Analyst David Song’s report “EURUSD: Trading the FOMC Interest Rate Decision

It is widely anticipated at the Federal Open Market Committee rate decision today that the Fed Funds rate will be kept unchanged between 0.00 and 0.25 percent. While the rate decision is due at 12:30 EDT / 16:30 GMT, the key parts of today’s Federal Reserve events come a few hours later, when the Fed releases its revised economic projections for the economy at 14:00 EDT / 18:00 GMT, just ahead of Chairman Ben Bernanke’s press conference at 14:15 EDT / 18:15 GMT. With US growth figures slowing alongside a weaker than expected labor market, market participants are widely expecting that some new form of accommodative policy will be introduced.

Certainly, in the inter-meeting period, rumors have floated that the Federal Reserve is considering another round of quantitative easing, but views have ranged as to what type of easing package it may be: an asset purchases targeting mortgage backed securities (ala QE1); an outright bond purchases (ala QE2); a further ‘twist’ of the Fed’s balance sheet (ala Operation Twist announced in September, concluding at the end of this month); or even a sterilized bond purchase program that involves the Fed using one- to four-week reverse repos (thereby avoiding increasing bank excess reserves).

While we believe that there will be some indication of easing, we do not believe it will be on the scale of QE2 – outright bond purchases intended to flatten the yield curve. Instead, we believe it will be an extension of Operation Twist. Currently, the Fed has just under $200 billion in short tenor securities left on its balance sheets, which means if the Fed were to continue Operation Twist at its current rate, the program would end in September. Accordingly, this will buy more time for the Fed to assess the economy and devise new ways to help promote growth.

In terms of what the market is expecting, calls have been high for a QE3 package, especially among the Fed’s more dovish members such as Charles Evans (who last week stated that he would support any form of more accommodation), but it’s important to note that the Fed voting bloc has been a bit more conservative lately (on the whole, most have suggested a “wait-and-see” approach).At his Congressional testimony a few weeks ago, Chairman Bernanke made it clear that the Fed would not fill the void created by the US’ irresponsible fiscal policy, and that the Fed could only do so much to achieve its dual mandate of price stability (with Core inflation near 2%) and maximum employment.

These expectations for QE3 have been strong since the dismal Nonfarm Payrolls report for May that was released on June 1.The Dow Jones FXCM Dollar Index (Ticker: USDOLLAR), after peaking on June 1 at 10312.73, has shed as much as 2.78 percent, falling as low as 10026.23 yesterday, the index’s lowest reading since May 15. In the past five days alone, since rumors emerged that the G20 was considering a globally coordinated intervention to help calm markets should the Greek elections yield an unfavorable result, the Dollar Index has dropped by as much as 1.53 percent. It’s fairly evident that the threat of more easing, an ultimately fiat-dilutive measure, has hurt the US Dollar’s prospects.

How Will the Market React?

Similar to the Operation Twist announcement in September 2011, expectations are high for a major easing package, not just a program that extends the duration of the Fed’s balance sheet. As such, this could result in a letdown, resulting in the selling of high beta currencies and risk-correlated assets in favor of the US Dollar.

AUDUSD 5-min Chart: September 21, 2011

FOMC_Will_Not_Implement_QE3_but_Other_Forms_of_Easing_Possible_body_Picture_4.png, FOMC Will Not Implement QE3, but Other Forms of Easing Possible

Charts Created using Marketscope – Prepared by Christopher Vecchio

As evident in the chart above, when Federal Reserve Chairman Bernanke announced that Operation Twist was coming, not a full-scale outright bond purchase program, the US Dollar gained traction quickly. The AUDUSD dropped from near 1.0230 ahead of the press conference to as low as 1.0055 by the end of the US cash equity session. Indeed, when expectations are riding high, there’s significant room for a surprise, and in this case, this could result in an explosive move higher by the US Dollar.

Key Pairs

QE3 ON: AUDUSD Bullish, EURUSD Bullish, USDJPY Bearish

QE3 OFF: AUDUSD Bearish, EURUSD Bearish, USDJPY Bullish

--- Written by Christopher Vecchio, Currency Analyst

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com

Follow him on Twitter at @CVecchioFX

To be added to Christopher’s e-mail distribution list, send an e-mail with subject line "Distribution List" to cvecchio@dailyfx.com

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20 June 2012 15:50 GMT