Pricing in, out, not enough or too much QE2

The lights were on, but no one could see. The market has been blinded by China’s surprise rate hike and Geithner’s promise not to devalue the dollar for export advantage. The lemming-dollar shorts have been rushing to the exits, looking to own dollars, on fears that China’s growth may soften further. Fundamentally, they have lost their ‘bottle’, fearing that the engine of the global recovery will slow as the PBOC seeks to curb lending and prevent a property bubble. The violent currency swings may be a tad overdone ever since Bernanke’s remarks last Friday. We have been pricing in, out, not enough or too much QE2 based on policy members rhetoric and personal thoughts. Sometimes it’s cheaper to sit out a dance or two. However, if the Fed is to disappoint market expectations for a QE ‘shock and awe’ campaign and deliver us a ‘lighter’ version then the dollar has much further to go.

The US$ is weaker in the O/N trading session. Currently it is lower against 13 of the 16 most actively traded currencies in ‘subdued’ trading range.

Forex heatmap

US data took a back seat to China’s surprising rate hike yesterday. Housing starts rose to +601k annual rate, up +0.3% from a revised positive Aug. release which happened to beat market expectations. Not as healthy was the surprising fall in Building permits. It dropped to its lowest level in over a year (+0.54k vs. +0.58k), as a plunge in the volatile multifamily area overshadowed a gain in single-family applications. Housing remains a drag on US GDP growth. Analysts note that with Sept. rounding out the third-quarter, new home construction activity is looking to come in at -2.1% lower than the second quarter. With permits declining -5.6%, it signals a pace of new home construction to be on the soft side in the coming months. Yesterday’s permits print is the first trend break lower from the tight range since May, signaling that activity is likely to be softer in future months. Unless permits accelerate, then the gain in starts is likely to settle back down in future months.

The USD$ is lower against the EUR +0.67%, GBP +0.14%, CHF +0.62% and JPY +0.51%. The commodity currencies are stronger this morning, CAD +0.40% and AUD +0.89%. There were no surprises in the BOC rate decision. They remained on hold (+1%) as the market had anticipated. It was the following communiqué from Governor Carney that raised a few eyebrows. Policy makers downgraded growth (+3% vs. +3.5%, 2010) and the inflation outlook (CPI and core inflation are now expected to converge to 2% at the end of 2012). There are a number of ‘factors’ in the way for another rate hike at present. The BOC said that the ‘more modest growth profile reflects a more gradual global recovery and a more subdued profile for household spending’. They did not go all out neutral on future rate hikes, but noted that certain factors stand in the way. First, weaker US outlook, second, constrains are beginning to moderate growth in emerging market economies and finally, domestic considerations are expected to slow consumption and housing activity in Canada. The loonie solidified its longest losing streak in two months on the BOC’s outlook and on the back of a the dollar gaining significant ground vs. all its major trading partners after the PBOC, in a surprise move hiked rates. The monetary tightening had little to do with their Yuan policy, but more to do with their domestic rising inflation. The net effect has weakened investor confidence in a global economic recovery amid concerns that China’s growth may slow further. Currently, growth sensitive and commodity driven currencies has investors thinking twice about paring some of their long positions.

The AUD won the battle of reaching parity, albeit briefly, and aggressively fell from its twenty-seven year high on speculation that the Fed would add less monetary stimulus than expected and after China tightened their monetary policy, damping demand for higher-yielding growth assets. Analysts note that going into next months Fed meeting’s that the ‘risks are skewed towards further disappointment’ which has the market aggressively pricing out some of the QE2 premium. This weeks RBA minutes showed that policy maker’s decision to keep interest rates unchanged this month had been ‘finely balanced’. On the other hand they did indicate that rates would have to ‘rise at some point’. From a fundamental perspective the minutes reinforced the argument that there could be another hike coming in Nov. or Dec. given that the RBA seems very comfortable with where the currency is currently. It has risen for the first time in four trading sessions as investors used the dollar rally as an opportunity to buy an oversold market. Month-to-date, the AUD has climbed +6.2% vs. the buck as data fueled bets that the RBA will raise interest rates before the year ends. Investors are better buyers on deeper pullbacks as the interest rate differential continues to be of appeal for alternative investments (0.9777).

Crude is higher in the O/N session ($80.61 +$1.12c). Crude tumbled the most in six-weeks yesterday after China raised benchmark interest rates, potentially reducing demand in the world’s biggest energy-consuming country, and the dollar rose against the EUR. The market fears that China’s move will harm future economic growth. Analysts note that ‘increased lending rates and deposit requirements will reduce available liquidity in the market and could engender slower growth, adversely affecting demand’. This morning we get the weekly inventory report and the market anticipates stocks to rise. Last week’s report revealed a small drawdown on stocks. Crude fell by -416k barrels to +360.5m, compared with the estimated increase of +1.2m barrels. Crude analysts note ‘this is currently a shoulder season for product demand ahead of the winter heating season’. Technically, we should expect inventories to gravitate towards their highs. Not to be left in the cold, gas inventories fell -1.8m barrels to +218.2m, just above the weekly estimate of a -1.4m drawdown. Distillate stocks (heating oil and diesel), fell by -255k barrels to +172.21m. Finally, the refining capacity fell by -1.2% to 81.9%. It seems that the drop in refinery runs has probably caused the drop in fuel supplies. The market remains wary that the underlying fundamentals have not changed despite prices remaining rangebound.

Gold had its largest one day fall in three-months yesterday. It erased all of last weeks gains, as the dollar rose against all its major trading partners after China surprised the market by hiking interest rates. In this mornings session it has managed to claw back some lost ground. The PBOC decision to raise rates put perceived risk currencies, including the EUR under pressure. Higher interest rates tend to have a negative affect on the yellow metal. Analysts expect the pull back to be well supported ahead of Fed meeting next month and the G20 later this month. Year-to-date it has been a commodity in demand for alternative investment purposes. Last week, the market traded with a distrust of currencies and gold seemed to be the only solution as investors used it as a proxy for a ‘third reservable currency’. With market confidence wavering in currency prices, and with cheap money, has made commodities look attractive on pull backs. To date, gold has outperformed global equities and treasuries (+21.8%), prompting record investment in gold-backed exchange-traded products. The debasing issues of the dollar, coupled with the sustainable growth issues of the US economy have had investors generally seeking protection in an asset with a ‘store of value’. With the Fed on the verge of implementing further QE programs ‘tend to be supportive of asset prices and is fueling concerns about the potential longer-term inflationary affect of such measures’. The opportunity costs of holding gold are low due to low interest rates ($1,342 +$6.10c).

The Nikkei closed at 9,381 down -157. The DAX index in Europe was at 6,501 up +11; the FTSE (UK) currently is 5,707 +4. The early call for the open of key US indices is higher. The US 10-year eased 4bp yesterday (2.48%) and is little changed in the O/N session. Longer dated securities prices remained close to home yesterday as several Fed officials expressed the need for more policy easing was offset by bank earnings and better-than-expected housing data. Lockhart (Atlanta) and Evans (Evans) chimed in, stating ‘much more’ monetary accommodation was warranted to counter low inflation and high unemployment, a week after helicopter Ben signaled that QE2 was likely. Deeper pull back are to be bought.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Dean Popplewell

Dean Popplewell

Vice-President of Market Analysis at MarketPulse
Dean Popplewell has nearly two decades of experience trading currencies and fixed income instruments. He has a deep understanding of market fundamentals and the impact of global events on capital markets. He is respected among professional traders for his skilled analysis and career history as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006, Dean has played an instrumental role in driving awareness of the forex market as an emerging asset class for retail investors, as well as providing expert counsel to a number of internal teams on how to best serve clients and industry stakeholders.
Dean Popplewell