Currency Outlook After Yesterday's FOMC Meeting

Thanks to Federal Reserve Chairman Ben Bernanke, we have enjoyed a very nice rally in currencies and equities. The central bank pledged to keep monetary policy highly accommodative for the next 2 to 3 years and interest rates to remain at extremely low levels until late 2014. Up until December, the central bank had only committed to keeping rates steady until 2013, but , they not only extended this pledge by one year but Bernanke also said more bond purchases could be necessary. Investors were delighted to hear this news even though it meant that the central bank was less optimistic about the outlook for the economy. The reason is because low interest rates make it more affordable to borrow, lend and spend for consumers and businesses alike. The sharp sell-off in the dollar suggests that many investors had not anticipated such a clear willingness by the Federal Reserve to fire up the printing presses. The central bank’s announcements gave investors strong reasons to sell dollars and there is a good possibility the greenback will extend its losses as long as key resistance levels are breached. The rally in the EUR/USD has been powerful but without a break above 1.32, which is a former support turned resistance level, the downtrend in the EUR/USD remains intact. The GBP/USD rally also stopped short of the 100-day SMA which is an important resistance point while USD/JPY has its own narrow ranges to contend with. From a fundamental perspective, the Fed has planted the kiss of death on the dollar, but the reason why they remain so dovish is because of concerns about Europe.  If its troubles worsen, wrecking havoc on the financial markets, deleveraging could promptly send investors back into the arms of the greenback. In other words the roof can come crashing down at anytime on the EUR/USD rally. Technically, many currency pairs still need to break key levels before they can say that they have shook off their downward momentum. This does not mean that the dollar cannot slip further but it may not be as smooth of a ride as many would expect.

The goal of the announcement was to increase transparency but in many ways, releasing the individual projections for the first rate hike created more confusion than clarity. It wasn’t until Bernanke started to talk about more bond purchases did investors understand the message. While the statement exuded a sense of solidarity, the individual projections show significant division in the central bank. Of the 17 participants in the FOMC, 3 expect the Fed to raise rates in 2012, 3 in 2013, 5 in 2014, 4 in 2015 and 2 in 2016.   In other words, 6 FOMC participants see interest rates increased before 2014 and 6 see rates increased in 2014 or later. As confusing as this may be, interest rate hikes are not on anyone’s radar. Instead the key question was whether the Fed would fire up the printing presses this year and according to Bernanke additional bond purchases remains an option. In fact, he spoke about the central bank’s readiness to expand their balance sheet so many times during his press conference that we can’t help but wonder if he is plans to pull the trigger on QE3 in March. Over the next few weeks, we will be listening to the speeches by FOMC voters carefully to hear if there is a consistent message about more bond purchases. If so, the dollar could extend its slide but this would be contingent upon the situation in Europe. If nothing comes out of the EU Leaders Summit next week and CDS spreads in Europe start to rise, then U.S. dollar traders could quickly forget about the U.S.’ easy monetary policy and return to taking its cue from Europe. For more on the FOMC Rate Announcement, please read our Instant Insight .

EUR: BEHIND THE RALLY

After reaching a low of 1.2613 on January 13, the EUR/USD has staged a remarkable rally. Not only has the pair appreciated 6 out of the last 7 trading days, but it is now trading at a year to date high. The strength euro comes from the resilience of investors who keep buying European bonds, keeping yields and CDS spreads from rising. It also has to do with better economic reports out of Germany and the overall improvement in risk appetite. It is hard for investors to be gloomy when equities continue to rise. For example, Germany reported a surprising improvement in business confidence. The IFO index rose from 107.3 to 108.3 as businesses grew more optimistic about the current and future conditions. Many experts predict a recession for the Eurozone this year but so far incoming economic data show more growth than contraction.  With this in mind however, conditions in the Eurozone can get ugly quickly. We cannot ignore the ongoing risks posed by the sovereign debt crisis and inability of European officials to concede and agree.  The European rescue fund needs more money but no one is willing to make the commitment. German Chancellor Merkel expressed her opposition to the idea by saying that increasing the rescue fund will not work. She argues that if they double the size, then they will be asked to triple it. Foreign nations on the other hand refuse to help because they believe that Europe has not done everything in their power which creates a vicious cycle where foreigners are not willing to help Europe and the Europeans are not willing to help themselves.  The European Central Bank is under pressure to take losses on their Greek bond exposure but they refuse to do so because it would damage the credibility of the ECB and its ability to support other vulnerable nations. The market may be getting tired of the European sovereign debt story but in no way shape or form are the troubles over.

GBP: FOURTH QUARTER CONTRACTION

The British pound strengthened against the U.S. dollar but weakened against the euro. The U.K. economy shrank more than expected in the fourth quarter as manufacturers cut output and services sputtered, leaving Britain teetering on the brink of a double dip recession. Gross domestic product fell 0.2 percent from the third quarter, when it increased 0.6 percent and expectations were for a contraction of 0.1 percent. Bank of England Governor Mervyn King said that policy makers can increase stimulus again if needed to guard against another downturn. While a technical recession – an instance in which GDP contracts for two consecutive quarters – cannot be ruled out at this point, there are still signs of a slow recovery. A look at the minutes of the central bank’s Jan.11-12 meeting published today shows policy makers increasingly saying more quantitative easing is “likely.” Policy makers fear undershooting the inflation target and expressed that another round of asset purchases will likely be required. But the central bank felt no pressing need to increase the program before completing the purchases that have already been announced. All nine of the monetary policy committee’s members agreed to keep the interest rate at a record low of 0.5 percent and to leave its asset purchases at 275 billion pounds. Their outlook remains that U.K. output is likely to be broadly flat over the six months to the end of the first quarter. The CBI retail sales numbers are due out tomorrow. The index posted a 9 in December and is expected to show a negative 2 for January. A positive surprise would provide hope that the U.K. could avoid a double dip.