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Fed Hints About the End of Quantitative Easing

Fed Hints About the End of Quantitative Easing

Kathy Lien, Technical Strategist

The latest FOMC meeting minutes went so far as referencing a potential end to quantitative easing (QE), a development that carries major weight for the dollar, euro, yen, and British pound, among others.

Currencies, equities, and commodities reacted strongly to the Federal Open Market Committee (FOMC) minutes on Wednesday. The meeting minutes indicated that in the month of January, many Fed officials were concerned about the "efficacy, costs, and risks of asset purchases." Furthermore, comments stated that an ongoing evaluation of these factors could lead the "Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred."

In plain English, this means that Fed officials could end quantitative easing (QE) way before the 6.5% unemployment target is reached. As shown in the most recent producer price report, inflation is not the main problem. Policymakers are worried about the potential volatility and increase in interest rates that could occur when they decide to sell assets. Therefore, they want gradually ease the flow of assets back into the market to avoid any shocks to the economy.

The fact that the discussions regarding the phasing out of asset purchases have gained traction suggests that the Fed believes that the US economy is on firm enough footing to handle a slowdown in asset purchases. In response, the US dollar (USD) has soared and stocks have fallen.

While we are not surprised that Fed officials talked about phasing out asset purchases again (in fact, we told readers to expect it), we were surprised by how willing they are to look beyond the 7.9% unemployment rate. Of course, it won't be easy to unwind asset purchases when the time comes, but we expected them to do so when the economy was performing better and was more able to handle asset sales.

Recent economic data, including the latest housing report, shows the economy recovering very slowly, and we expect Thursday’s jobless claims, CPI, Philly Fed, and existing home sales reports to paint a similar picture of sluggish growth.

The rally in stocks has helped to support consumer sentiment, but it has yet to translate into stronger spending. Nonetheless, our skepticism matters little when investors have bought dollars this aggressively. We expect this rally to continue as long as policymakers do not backpedal on the discussions.

Fed Presidents James Bullard (St. Louis), John Williams (San Francisco), Richard Fisher (Dallas), and Federal Reserve Board member Jerome Powell will be speaking over the next 48 hours, and they will undoubtedly be asked about the central bank's plans, but the real test will be Fed Chairman Ben Bernanke's semi-annual testimony next week. If Bernanke confirms that asset purchases are being reviewed, this rally could become a real turnaround in the US dollar. If he downplays the possibility and suggests that these are very initial discussions, the dollar could give back its gains quickly.

EUR: Will PMI Numbers Save the Euro?

The euro dropped to a one-month low against the US dollar Wednesday on the back of the less-dovish FOMC minutes. The fate of the EURUSD now lies in the hands of Thursday’s Eurozone PMI numbers.

The only factor preventing a deeper slide in the euro is the stability of the German economy. Germany is carrying the entire Eurozone on its shoulders, and according to this week's ZEW survey, investors expect this trend to continue. The PMI numbers will give us a sense of how much cushion Germany and the Eurozone really have. If the data continues to surprise to the upside with the manufacturing and service sectors in Germany growing at a faster pace in the month of February, the EURUSD could find support after Wednesday’s sharp selloff. However, if the data surprises to the downside, investors will look at the more dovish comments from the European Central Bank (ECB) versus the less-dovish comments from the Federal Reserve and drive the EURUSD lower.

The euro was already under pressure before the FOMC minutes because Spanish Prime Minister Mariano Rajoy said the decline in the nation’s public debt levels will fall short of the European Union's consensus target of 6.3%. The 2012 deficit is expected to come in under 7%, which we believe is still good news for Spain because anything below 8% limits the risk of a downgrade.

British Pound Hits 2.5-Year Low Versus Dollar

The British pound (GBP) dropped to a 2.5-year low against the greenback after the Bank of England (BoE) minutes revealed one additional member voting in favor of easier monetary policy. Between weaker economic data, deteriorating fiscal finances, the prospects for easier monetary policy, and the risk of a sovereign debt downgrade, investors have pulled out of sterling quickly and aggressively. We believe that this trend will continue, as there is no support for GBPUSD until 1.50.

See related: 4 Key FX Market Drivers to Watch Now

Since the beginning of the year, we have been saying that one of the greatest risks for the UK is a sovereign debt downgrade, and it appears that this notion is gaining traction in the markets. UK public sector finances are due for release on Thursday, and a decline in public sector net borrowing is expected, which would only add salt to the wound.

See also: New S&P Downgrade Rumors Rock EUR/GBP

Central Bank Comments Shoot Down New Zealand Dollar

The worst-performing currency was the New Zealand dollar (NZD), which fell nearly 1.4% against the greenback. The selloff was caused by comments from Reserve Band of New Zealand (RBNZ) head Graeme Wheeler, who suggested that the NZD was overvalued and that the central bank stood ready to intervene, if necessary.

See related: Kiwis’ Unusual Currency War Battle Plan

Having failed at intervention in the past and admitting that they don't have the resources to control the currency, intervention is not a realistic risk for New Zealand. However, with economic data improving, Wheeler is trying to prevent the NZD from being a one-way trade. As long as there is more upside than downside surprises in New Zealand’s data, we still think the NZD is headed higher.

The Australian dollar also traded sharply lower on the back of weak leading indicators and slower annualized wage growth. Another monthly decline in Canadian housing prices kept the Canadian dollar (CAD) under pressure, and the currency extended its losses after the FOMC minutes.

Weak Yen Hurting Japan's Trade Balance

The Japanese yen (JPY) traded higher against all major currencies except for the US dollar, which benefitted from the FOMC minutes. While the Fed's discussion about phasing out asset purchases helped USDJPY, it was still not enough to drive the currency pair to fresh highs.

Yen traders are waiting for the next catalyst to come out of Japan, and we believe that it will come from the nomination of the new Bank of Japan Governor. That announcement can come any day now, but is likely to occur right either right before or after Prime Minister Abe returns from his visit to the U.S. early next week.

See related: The Only USD/JPY Catalyst That Matters

Based on the latest trade numbers, Japan's economy needs a lot more help. Despite the significant amount of Yen weakness that has occurred over the past three months, Japan's trade deficit ballooned to a record high of 1.629 trillion yen.

What was interesting about the results was the fact that exports increased for the first time in eight months, but it was not enough to offset the impact that the weak yen had on Japan's energy import bill. The combination of higher oil prices and a weaker currency pushed the value of imports up 7.3%, and this is an example of how a weak currency can also hurt trade activity.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.