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Today is all about Bernanke and the FOMC meeting that concludes later today. The main questions the markets want answered is 1, will we get more QE this month, 2, what form will it take, and 3, what size will it be? The markets seem to have made up their mind on the first question the Fed will act because of the unambiguously bad payrolls data in August and also after Bernanke's defence of conventional QE at the Jackson Hole conference last month. We tend to agree that if the Fed doesn't announce more QE today then it could be accused of leading the markets on, but the big unknown is how large the programme will be and if it will follow the same format as QE 1 and 2.

Can the markets buy the Fed rumour and the Fed fact?

Obviously if Bernanke doesn't announce QE later today then expect a sell-off across all global asset classes and for the US dollar to soar. This would be particularly acute for USDJPY, the cross considered most sensitive to changes in monetary policy, as we could reverse sharply back to 80.0 in no time. But assuming he does announce more QE (a risky strategy, I know) then Bernanke may not only be known for his put, but also for his call. The markets have rallied into this FOMC meeting, will the rally continue afterwards? It depends on the size and scale of the action. We tend to think that the Bank will announce at least $500bn of asset purchases that will be split between Treasuries and mortgage-backed securities (MBS).

Why unlimited bond purchases are a bad idea

There are two reasons for purchasing a variety of assets: 1, the housing market remains in the doldrums and could do with some precision targeting by the Fed, 2, the Fed already owns such a large chunk of the Treasury market through QE1 and 2 and thus it is at risk of being accused of monetizing the enormous US debt burden if it focuses just on Treasuries. Regarding the size of any potential programme, we think any new programme could be at least $500bn in size, maybe even larger. Some have argued for an unlimited QE programme with specific economic targets to determine when asset purchases should stop, however that is an extremely risky strategy for the Fed as it exposes the Fed's balance sheet to an unknown liability. There is no way of knowing if there had been unlimited QE1 back in 2009 that it would have brought down the unemployment rate at a faster pace. Thus, with no sign of the economy picking up any time soon and some large economic risks on the horizon like the fiscal cliff, the Fed may not want to commit itself to an unknown quantity of asset purchases at this point in time.

The biggest impact on the markets would be unlimited purchases, in our view, which could see risky assets like stocks and commodities move higher. EURUSD could hit 1.30 and AUDUSD could surge above 1.06, the high from July. As mentioned above, USDJPY is usually extremely sensitive to changes in US monetary policy, however, an aggressive QE programme could cause this pair to rapidly dip below 77.00 back to February's lows. However, this could invoke the ire of the Japanese authorities and any sharp moves lower in USDJPY would increase the chance of the Japanese authorities intervening in the FX market to limit JPY strength. Gold is also likely to be sensitive over the Fed announcement later, see our one to watch below for more on this.

SNB ponders more action on Swissie

The Swiss National Bank kept interest rates on hold today and also kept the EURCHF peg at 1.20. There was some expectation it could raise the peg to 1.22 or even higher. EURCHF has been volatile this morning, and it backed away from its 1.2130 high on the announcement, finding support at 1.2100. EURCHF has jumped higher in recent days on the back of the ECB action to stabilise the sovereign debt crisis and also due to expectations the SNB could lift the EURCHF floor. Although the SNB seems in wait and see mode for now, it could act later if the economic data doesn't start to pick up. Swiss GDP fell in Q2 and exports to the Eurozone continue to weaken. The SNB has already revised lower its 2012 growth forecast to 1% from 1.5%. It also revised lower its inflation forecast. If the economy continues to dip then deflation pressures will rise, which could spur the SNB to do more to reduce Swissie strength. Thus, we don't see EURCHF falling too sharply in the coming weeks and it could remain above 1.21 in the medium term.

Europe seems to have taken a back seat as the focus shifts to the Fed and the US fiscal problems. The ECB announcement of the OMT programme from last week continues to have a soothing effect on the markets as does the pro euro Dutch election victory and the German Constitutional Court decision. Italy also had a successful bond auction this morning. It sold 2015, 2017 and 2026 bonds for some of the lowest yields in the last three months. Italy's 10-year bond has continued to fall today and remains just above 5%. Spanish bonds are actually higher this morning, but they still remain at some of their lowest levels since March this year. Portugal, which is considered at risk from a second bailout, also saw the cost to insure its debt from default drop to its lowest level since March 2011 earlier. The stabilization in peripheral debt markets has helped the euro rally, so even if we get a disappointment from the Fed later today we think that euro losses could be capped and we don't envisage a fall below 1.25 in the medium term.

One to watch: Gold

This cross is incredibly sensitive to central bank action as the yellow metal is considered the ultimate inflation hedge. After climbing as high as $1,745 per ounce earlier today we have seen some profit taking ahead of the key $1,750 level. Support lies at $1,730 then at $1,710. Things could be fairly quiet for gold until the Fed later today. If the Fed announces an aggressive programme of QE then we expect gold to surge above $1,700 and end the week somewhere around $1,800- $1,810 per ounce. If the Fed announces QE but in the region of $500bn of asset purchases then we could see gold fall back towards $1,680 before moving higher over the medium term. If the Fed doesn't announce more QE, but does suggest that it may do more QE sometime before the end of the year then we may see the gold price initially sell off sharply, before finding support between $1,630- $1,650 - a cluster of daily moving averages.

Gold daily chart


Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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