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Two things matter for the markets at the moment 1, the Eurozone debt crisis and the potential for it to be resolved and 2, the prospect of more QE from the Federal Reserve. The latter is important because markets love liquidity and for the last couple of years Ben Bernanke (The Fed chief) has delivered what the markets desired and announced it at his annual Jackson Hole speech. That speech, which takes place at a global central bankers' conference in the mountain resort, is on August 31st this year and expectations are building.

So what will impact Bernanke's decision?

The Fed has a dual mandate - it has to maintain stable inflation and also full employment. The employment picture is fairly bleak, it rose to 8.3% in July, but the number of jobs being created by the US is starting to pick up, which is positive. Overall, I would give the employment landscape in the US a 5 out of 10 at best. The next thing to evaluate is inflation. The Fed looks at a few inflation indicators, the first is CPI, which was released for July on Wednesday. Core CPI, which does not include food or energy, was flat between June and July and the annual rate fell from 2.2% to 2.1%. The other measure of inflation the Fed looks at is the personal consumption expenditure core price (core PCE), which measures the price changes of a variety of consumer goods. This had been falling for most of this year but has since started to rise modestly and is currently 1.8%. The Fed's target rate for inflation is approx. 2%, so inflation is roughly in line at the moment. The question for the Fed is if it will stay at this rate. If inflation continues to fall then deflation concerns will arise, which could spur the Fed to buy more assets to try and get money back into the economy.

Should we worry about deflation?

Since Fed policy takes a few months to feed into the real economy it would need to think about adding more stimulus in the next month or so if it believes deflation is a real threat. But does the Fed think deflation is a big threat? There are good arguments on both sides. No: inflation is unlikely to decline too far since oil and food prices are rising and if the labour market continues to pick up then we could see wages start to rise. Yes: The labour market is at such a delicate stage that wages are unlikely to become an inflationary threat and other economic indicators have been patchy suggesting that the recovery is at risk and the economy could do with a boost.

Waiting for Jackson Hole

But which way will the Fed swing and should we expect to hear anything at Bernanke's Jackson Hole speech on 31st August? The economic data suggests there are good arguments to be made on both sides of the QE/ no QE debate, the second thing to consider is the views of the voting members of the Fed and where they stand. Currently of the voting members of the Fed (which includes the alternate voting members and board members) the majority are either outright doves or moderately dovish, while Jeffrey Lacker, a voting member of the FOMC this year for the Federal Reserve Bank of Richmond, is the lone hawk on the board. Chairman Bernanke is in the centre although he has been known to lean towards dovishness in the past.

What does this all mean? Economic data at the minute is probably enough to leave the FOMC in wait-and-see mode, thus Bernanke may express the fragility of the economic recovery at his Jackson Hole speech, but we don't think he will announce more policy support. The reason for this is that 1, the economic outlook is incredibly cloudy 2, inflation is not falling dramatically as yet and oil and food prices are rising. 3, Treasury yields are already so low that more QE may not be effective, 4, so the Fed may need time to hone their creative skills to come up with policy support to suit the current economic conditions. 5, The Fed may not want to pump more money into the economy so close to an election, it may also not want its actions to cause the policy makers in Washington to take their foot of the pedal and not enact fiscal reform.

What does this mean for asset classes?

1, The dollar: the next couple of weeks could be dollar positive as the market prices out expectations of more QE from the Fed. The dollar index is extremely sensitive to data releases as we lead up to the Jackson Hole meeting. Although it sold off post the slightly weaker inflation report on Wednesday, positive data surprises are having a bigger influence on the dollar. Data to watch in the next couple of weeks include: durable goods orders (24/08), consumer confidence (28/08) the second reading of Q2 GDP (29/08) and PCE (30/08). The DXY is testing 82.60 - its 50-day moving average, above here opens the way for a move towards 84.00 in the medium term. If we break above the 50-day sma resistance in the DXY then we may see further weakness in other dollar crosses like EURUSD and GBPUSD. In EURUSD, below 1.2275 opens the way for a move towards 1.2250 and then 1.2150 in the short to medium term.

EURUSD: Daily chart



2, Stocks: equities love liquidity and have rallied hard in the past when the Fed announces new asset purchases. Thus if Bernanke does not announce more stimulus at this year's meeting stocks may sell off. Adding to the downward pressure facing stocks, the economy is fairly patchy and earnings results for Q2 were fairly poor, leaving the corporate sector with a mountain to climb to reach their 2012 full year earnings targets. The S&P 500 positive surprise index (which measures the percentage of companies who reported earnings above the Bloomberg estimate) fell from above 80% in April to 68% in August.

Thus, without Fed support we could see the SPX struggle to maintain momentum above 1,400 and we could see a pullback to the 1,350-80 area. If we get below 1,340 - a cluster of daily moving averages - then that may be a signal that something more serious is going on and we could get a further decline towards 1,300 and then 1,275. I am not sure a full blown sell off is on the cards, as some people may buy the SPX 500 on any dips if they think that no more QE is a good sign that the economy can get by on its own steam rather than lean on the Fed. If the Fed does throw a bone to the markets then the SPX could meander higher towards 1,450 in the medium term.

SPX 500: daily chart



Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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