Fed May Disappoint Many Dollar Bulls
Despite a considerable improvement in financial markets, the Federal Reserve is widely expected to keep its benchmark interest rate unchanged at 0.25% to 0%, a record low. Indeed, economic activity remains constrained by ongoing job losses, lower housing wealth, and tight credit”, the Federal Open Market Committee recently said. However, it will be interesting to see if the Fed expresses some concern about inflation since energy prices and soft commodities have risen of late (sugar is up by more than 30% YTD). The dollar has been well bid ahead of the rate decision on speculation the resumption of economic growth in the United States will lead to a positive shift of interest rate differentials in favor of the dollar. Yet, investors will be disappointed if the Fed fails to signal an exit strategy for quantitative easing.
Interest Rates Across the World (roll your mouse over the map to see rate levels)
Fed’s Quantitative Easing Continues to Weigh on the Dollar
Despite the recent improvement in investor’s confidence, the US Federal Reserve continues to take a number of actions to increase liquidity and stabilize financial markets. Indeed, the Federal Open Market Committee continues to anticipate “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period”. Moreover, “to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets”, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn”. However, notwithstanding the short-term benefits of an aggressive monetary policy, the Federal Reserve really needs to start thinking about long term implications of its current actions. In particular, the Fed needs to announce an exit strategy for quantitative easing before investors start questioning its policy mechanisms to achieve sustainable growth. Apparently, the US Treasury is monetizing the government deficit by printing out money for the Federal Reserve to purchase bonds. However, this is a strategic mistake because it’s unsustainable. In fact, the US public debt now stands at 11 trillion continuing to increase an average of $3.92 billion per day. Eventually, inflation will spike higher since more money will be available for the same quantity of goods. Among other things, inflation fears could force the Fed to increase the benchmark interest rate which could slow down growth and plunge the US economy into stagflation. In fact, several months of quantitative easing combined with expectations for a record government budget-deficit are already taking its toll in the dollar exchange rate. For instance, the dollar lost substantial value against the euro during the last 4 months. The EUR/USD rallied more than 1800 pips since March trading from a low of 1.2455 to as high as 1.4337 in July.
Forecast for the US Dollar
Alan Greenspan once said that “having endeavored to forecast exchange rates for more than half a century, I have understandably developed significant humility about my ability in this area”. I certainly did not spend 50 years researching exchange rates but I had my share of failed forecasts already. Having said that, in the near-term we think the US dollar is likely to remain under heavy selling pressure until the US Federal Reserve announces a clear exit strategy for quantitative easing. However, in the long-term, the resumption of economic growth in the United States is likely to influence the Federal Reserve monetary policy and lead to a positive shift of interest rate differentials in favor of the US dollar. So, because we have several opposite forces driving the current dollar exchange rate, we will probably see both the EUR/USD and USD/JPY trading in relatively tight ranges throughout the third quarter of 2009. In sum, look for opportunities to sell-short any major dollar rally but also don’t forget to buy excessive losses in the dollar exchange rate.
Antonio Sousa is a Chief Strategist for DailyFX.com at FXCM in New York City where he performs global economics research and develops systematic trading strategies. Please send your comments to firstname.lastname@example.org.