Fundamental Update: Fed QE3 Prospects Improving; USD/Risk Dynamic Shifts

In our 1Q 2012 Markets Outlook, we suggested that the Fed would move toward a third round of asset purchases in late 1Q/early 2Q, specifically targeting US housing via mortgage backed securities (MBS). This past Friday, a quartet of Fed speakers, led by NY Fed Pres. Dudley, all expressed frustration with continued weakness and the pace of recovery in US housing markets. They all in one form or another also suggested that policy makers need to do something more to support the recovery in housing, in some cases referring to potential Congressional or Administration initiatives, but leaving the door open for additional responses from the Fed. And just yesterday, Atlanta Fed President Lockhart (FOMC voter) indicated similar concerns about the drag from weakness in real estate holding back the overall US recovery. Importantly, Lockhart said he had an ‘open mind’ about additional stimulus, where previously he indicated that additional stimulus should be reserved in case of another dip into recession. Taken together, these Fed officials’ comments suggest to us there is an increasing sense of urgency at the Fed to do something more to support the US recovery, and their allusions to housing reinforce our view that a targeted round of asset purchases aimed at MBS is still on the cards.

Timing, however, is always the issue, and we think the public comments by the Fed officials above indicate further movement toward QE3 than was evident just last month. We still don’t think there will be a sufficiently strong consensus for QE3 by the Jan. 25 FOMC meeting to influence the policy statement and we maintain the view that the March 13 meeting is the earliest we’ll get a concrete indication that QE3 is in the works. But we’ll also keep a sharp eye out on Feb. 15, where the release of the Jan. 25 FOMC minutes could reveal further movement toward a consensus for additional asset purchases.

More importantly for near-term trading considerations, we think markets are keenly following incoming US data for what it portends for QE3 prospects and are increasingly trading the USD on that basis. This is at odds with patterns of much of late-2011, where the USD was frequently traded based on risk sentiment: risk on, USD down/risk off, USD up. Now it appears the relationship has shifted to include chances of QE3, diluting the safe haven role of the USD. Most recently as seen in better US December employment data from last Friday, as US data shows signs of strength, the odds of QE3 are seen to weaken and the USD consequently strengthens. This is very different from past months, where better US data would have bolstered risk sentiment and seen the USD weaken. Conversely, if US data begins to show signs of backsliding in coming months, which we expect, the prospects for QE3 will improve, and this should be USD-negative. It’s too soon to say how other risk assets (stocks/commodities) ill behave in this environment, but we can easily foresee that risk assets could initially weaken alongside the USD if data begins to disappoint more seriously, until those other risk assets have more concrete indications that QE3 is on the way. In the meantime, we would caution traders to be aware of the shift in the USD/risk sentiment relationship and begin to factor in the prospects for QE3 as part of their data reaction calculus.