- End in sight for Fed's open-ended QE
- Congress buys time but US budget talks still a key risk
- ECB dovish, but may hold on rates for now
The release of the December FOMC meeting minutes was somewhat of a surprise to markets as members discussed a possible end to the current round of quantitative easing (QE). Minutes showed that a few members on the committee wanted QE until about the end of 2013 while several backed slowing or stopping purchases well before the end of 2013. The initial reaction in the markets saw Treasury yields and the USD rise, while stocks dipped on the prospect of reduced Fed stimulus.
More importantly, with an end in sight to QE markets are likely to be more sensitive to economic data releases. The market interpreted the FOMC minutes as being less dovish which indicate that previous expectations were for a more prolonged asset purchase program. Due to these expectations and the “open-ended” nature of the program, surprises in economic data did not have as significant of an impact as it did not materially alter the outlook for Fed stimulus. Now, positive data surprises may signal an earlier end to QE as Fed members are viewed as supporting a halt to the program this year.
In addition to strong economic data being supportive for the dollar, less printing by the Fed should also be a positive for the USD. At a pace of $85B in monthly asset purchases ($40B in Treasury securities, $45B in mortgage-backed securities or MBS), the Fed will inflate its balance sheet by just over one trillion dollars if the current round of QE is implemented at its current rate throughout the end of 2013.
Economic data back is in the driver seat and risk-on/risk-off trading is likely to be less of a factor influencing the USD. A positive data surprise which, in a risk-on/risk-off environment, would see risk sentiment improve and the dollar weaken and vice versa. With monetary policy speculation back on the table, a positive US data surprise would suggest an end to easing is more imminent and would therefore be a positive to the dollar.
Keep in mind that this paradigm may not have shifted entirely just yet. We still require further clarification from Fed officials as the conditions for the end of asset purchases remain unclear, unlike the specific thresholds for ending the exceptionally low interest rate policy. It is also important to wait to see what the new FOMC voters (Bullard, Evans, George, Rosengren) have to say about the matter.
As noted in our Q1 outlook, we think that the incoming FOMC voters may be slightly more dovish than the current committee as Rosengren and Evans will be rotating into voting positions. George is likely to replace Lacker as the dissenter and Bullard is likely to lean on the hawkish side.
Congress buys time but US budget talks still a key risk
US politicians have averted the full force of the fiscal cliff with the passing of tax reforms and delaying of spending cuts. Growth in the US is still likely to take a small hit with tax hikes but of more urgent concern is the issue of the debt ceiling. The Treasury has indicated that the $16.4 trillion debt limit has been reached this past Monday and is now engaging in extraordinary measures to buy additional time.
About $200B of headroom is available, which should last roughly two months. This is the same amount of time that Congress delayed sequestration. This sets the stage for intense political debate regarding the US budget in the coming weeks and with disagreement between Democrats and Republicans, this is likely to weigh on risk sentiment.
Both private and official institutions weighed in on action taken by Congress and urged that more is needed. The IMF said that it welcomes the move, however the IMF also advised the US to remove uncertainties regarding the spending sequester and to raise the debt ceiling “expeditiously.” The ratings agency Moody’s indicated that more measures are needed for the US outlook to return to stable and also warned that “lack of further deficit reduction measures could affect the rating negatively.”
ECB dovish, but may hold on rates for now
The European Central Bank (ECB) will hold its first meeting of 2013 next Thursday and at the last meeting, the Bank’s stance turned notably dovish. Several members were said to have favored cutting interest rates should economic conditions deteriorate. The ECB’s main refinancing rate is currently at 0.75%, the deposit rate is currently at 0.0% and, marginal lending rate at 1.50%.
Though Draghi said that the ECB is “operationally prepared” for negative interest rates, we do not think that the Bank is ready to cut rates yet. Economic activity remains weak, however inflation remains above the central bank’s 2% target with eurozone inflation at 2.2% y/y in December. Also of note, Germany’s inflation accelerated to 2.1% y/y in December.
We anticipate that ECB monetary policy will remain on hold next week and that President Draghi will reiterate that the Bank stands ready to initiate sterilized bond purchases via its OMT program. With no change in policy expected, the tone of the statement and any clues as to the timing of a rate cut is likely to dictate price action. Technically, EUR/USD has fallen sharply after being rejected from the 1.33 figure.
The pair looks to have found support around the 1.30 level which is a key psychological level. This is also where a rising trendline comes in (which can be drawn from July lows) as well as the 23.6% Fibonacci retracement of the rally from July lows to December highs. Furthermore, the 55-day simple moving average (SMA) resides just below the 1.30 big figure which may provide added support.
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