FED’s Desperation Sees Red

Desperate times call for desperate actions. The Fed did was expected of them. They have introduced something innovative. Bernanke and company have reverted to “operation twist”, a program that has not been implemented in nearly half-a-century. The problem, is that yesterday’s announcement doe not provide new liquidity to a financial system where the market already sees European liquidity crunch intensifying. Policy makers did however surprise dealers with the size and targeted maturities to be bought in the program, but, basic growth concerns remain.

The market does not have a handle on what these asset purchases really mean and its the reason risky assets have performed so poorly. It may be month’s before key uncertainties on Europe and US growth dynamics have been addressed sufficiently to see the market exit from this “panic”.

Until then, pro-dollar and yen momentum trades likely have further to run. Especially now that Soros is marketing the ‘double-dip’ experience and this morning’s fall in the euro-zone composite PMI. Falling below the theoretical 50 “no-change” barrier provides the strongest sign yet that the region is on the cusp of recession.

Forex heatmap

US data did little for the dollar ahead of the FOMC announcement and this despite providing the market with a huge positive. US existing home sales blew analysts estimates out of the water by rising +7.7% to +5.03m units, m/m, from +4.71m and in stark contrast from the MBA and NAHB surveys. Analysts attribute some of the rise to a easing of restrictions on foreclosures, with distressed sales up +31% and to the recent declines in mortgage rates as longer bond yields fall. Regionally and as expected, Hurricane Irene had a negative impact on sales figures for the eastern part of the country. The y/y print looks somewhat distorted at +18.6%, inflated by the weak year ago data starting point shortly after a buyer’s tax credit had expired. On the positive side, inventory of unsold homes fell to +8.5 months from +9.5. Again disappointing was the price data weakening, partially due to the increased tally of foreclosures. The median price fell to +$168.3k from +$171.2k and is now only down -5.1% y/y compared to-6% before the release. The mean price fell to +$216.8k from +$220.4k in July.

Bernanke and company did what was expected of them. The Fed announced a new plan yesterday to stimulate growth by purchasing +$400b long-term securities with funds from the sale of short-term government debt, and in the process defied Republican demands ‘to refrain from new actions’.

The FOMC directed the Open Market Trading Desk to purchase, by the end of June 2012, +$400b in par value of Treasury securities with remaining maturities of 6 years to 30 years and to sell, over the same period, an equal par value of Treasury securities with remaining maturities of 3 years or less. The FOMC also directed the Desk to reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency MBS.

The Fed said that it was responding to evidence that there was a need for help, ‘growth remains slow with recent indicators pointing to continuing weakness in overall labor market conditions and the unemployment rate remains elevated’ . Their indicated that ‘household spending has been increasing at only a modest pace in recent months’. The program is aimed at reducing the cost of borrowing for businesses and consumers, including the cost of mortgages. The vote was 7-3 in favor for the new initiative. The innovative effort is an ‘experiment without a direct precedent’.

The dollars is higher against the EUR -0.73%, GBP -0.44%, CHF -1.33% and JPY -0.02%. The commodity currencies are weaker this morning, CAD -1.39% and AUD -1.44%.

The loonie completed its short term primary objective and printed parity before the FOMC announcement. It was here that it ran into large domestic corporate selling on the back of order books being tilted towards sellers. Post FOMC decision, short term US yields backed up and it was this that proved dollar positive and bad for carry and commodity sensitive currencies.

Yesterday’s data showed that inflation in Canada rose above the BoC comfort level last month as higher prices for gas and food pushed the rate up four notches to +3.1%, y/y. In times gone by, Governor Carney would have had his finger posed over the rate hike button. Not this time. Core-inflation also saw a sizable increase to +1.9% from +1.6%, pushing close to the BoC’s two-per-cent target. Earlier this week, Carney said he was not concerned about inflation and would not raise interest rates to deal with the issue. The bank’s mandate is to keep consumer prices within a range of +1% and +3%, and as close to +2% as possible. With the IMF stating that the global economy is entering a new “dangerous phase’, investors should expect inflation to moderate as demand diminishes. Presently Canada is experiencing the twin evils of a slowing economy and higher inflation. The Canadian economy remains at the mercy of ‘external headwinds’.

Governor Carney continues to apply the expected ‘dovish’ tone on the Canadian economy, explicitly noting ‘the need to withdraw monetary stimulus has diminished’. The Governor is becoming more concerned about global growth, especially now that the IMF has revised their growth forecasts. Investors are better buyers of dollars on dips (1.0273).

For the first time in six-weeks the AUD trades below parity as all commodity and interest rate sensitive currencies suffer outright. Data from Australia’s largest trading partner, China, indicates that manufacturing may contract for a third month in September as measures of export orders and output decline. A preliminary reading of 49.4 for a manufacturing index released earlier today compares with final readings of 49.9 for August and 49.3 for July. A reading below 50 indicates a contraction. China is Australia’s largest trading partner.

Despite Euro policy makers indicating that they are making some good progress with Greece, periphery yields remain elevated, heightening debt default uncertainty and requiring the paring of higher yielding risk portfolios. Other negative data has also pressured the currency this week. One of Australia’s mortgage insurers reported the percentage of mortgagees experiencing stress rose to +25% in July from +21% in June even as rental vacancies fell. Now that the domestic data is coming out a bit negative, there will be some questions ahead on what will happen to the Aussie economy. If anything, the RBA is likely to be on hold for an extended time, allowing investors to sell higher yielding assets on rallies. Liquidation of AUD may have be overextended in the short term as some investors currently look for opportunities to own the currency (0.9880).

Crude is lower in the O/N session ($82.86 down-$3.06c). Pre-FOMC, oil prices climbed after the weekly EIA report showed that US stockpiles declined to an eight-month low as refineries unexpectedly increased operating rates. Post-FOMC, crude prices plummeted as the Fed indicated that there were ‘significant downside risks’ to the US economic outlook.

This week’s EIA report showed that the US commercial crude oil inventories decreased by -7.3m barrels from the previous week. Analysts expected a-700k barrel decline. At +339m barrels, oil supply’s are above the upper limit of the average range for this time of year. This drawdown has left stocks at the lowest level in nine-months and was the biggest drop since December. Refineries operated at +88.3% of capacity, up +1.3% points from the prior week. On the flip side, gas inventories increased by +3.3m barrels last week and are upper limit of the average range.

Overall, the report was bullish, giving the sense that conditions are tight in the market place. Analysts note that there are a couple of variables that should keep oil prices in check, preventing them from running away on the top side, for instance, there’s set to be weaker growth as shown by the IMF, which points to lower oil demand, and production in Libya is coming on stream faster than expected. The market can expect to run into technically selling on rallies.

The yellow metal midweek rally was on the back of further European debt concerns. Risk-aversion investors were looking at gold as a safe haven prospect. Year-to-date, the commodity had risen +25% and is in the midst of completing its eleventh bull year. However, yesterday’s Fed announcement put a stop to the current bull run. Gold prices slumped just after the Fed’s introduction of more stimulus measures disappointed investors who previously bought, expecting a still-larger package, sold to exit from their contracts. Had there been even more stimulus measures, this would have raised the prospects for inflation even further.

In reality, the continued concerns over euro-zone sovereign debt are likely to drive gold higher before policy makers are forced to take more effective action. Some analysts believe that $2,000 a once is possible before year-end. The Fed’s efforts to drive interest rates lower to support lending should, by default, eventually support commodity prices. For now, liquidation for margin requirements take precedence ($1,765-$42.60c).

The Nikkei closed at 8,560 down-181. The DAX index in Europe was at 5,206 down-226; the FTSE (UK) currently is 5,065 down-222. The early call for the open of key US indices is higher. The US 10-year eased-13bp yesterday (1.80%) and is little changed in the o/n session.

US long-bond prices have surged, pushing the yields to the lowest level in two-years, after the Fed said it will purchase longer-term debt and sell shorter maturities to sustain the economic recovery. Yields on two-year notes rose after Bernanke said it will replace much of its short-term debt in its portfolio (Operation Twist). This was expected, but it has been seen as an aggressive move by the Fed. Their communique indicated that there were ‘significant downside risks’ to the US economic outlook, which should provide further support for treasuries and flatten the curve even further. The Fed is ‘firing another magic bullet’ and dealers intend to keep ahead of ‘that’ curve.

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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