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Greek elections have hogged much of the press coverage recently but today central banks have taken centre stage. There seems to be a couple of camps forming. The hawks and I use that term loosely to mean banks that may not loosen as much as the market expects (read RBA) or those who may start tightening in 2013 (Norges Bank) are gathering in one camp and those who are actively pursuing the loosening path (BOE) are in the other. We will know which camp the Fed sits in upon the conclusion of its meeting at 1730BST and Ben Bernanke's press conference at 1915 (1415 ET).

Central bank policy is one of the main drivers of the FX market so the relative position of global banks will be crucial to the medium-term direction of currencies. Essentially those who don't loosen policy may see upward pressure on their currencies, while those who do could see their currencies get sold off. The position of the Fed (still the most powerful central bank in the world) should be known at 1730BST (1230ET). If the Fed goes for more QE, which a large section of the market seems to think it will, then the details of the stimulus boost will be included in its statement. Bernanke will then elaborate on why it was done and if there could be more of it during his speech 95 minutes later.

Second-guessing the Fed

As much as I would love to be a fly on the wall at the Fed meeting, I am not and due to this there is no point guessing what it will do. At this stage the odds are fairly balanced. The reason why it might do QE: the Eurozone crisis is far from resolved, the labour market is showing signs of weakness, the markets have started to price in QE hence the rise in the euro, the SPX 500 etc. and the Fed doesn't like disappointing the market. Thus, the Fed may choose to do more QE as a premptive measure in case the economy gets worse over the summer and the Eurozone crisis blows up (again). However, the reasons for remaining on hold are equally compelling, if not more so in my view. Firstly, more QE is costly as the Fed would need to do at least $600bn worth of purchases of Treasuries, MBA's or both to have an impact. Secondly, successive attempts at QE tend to have a diminishing effect on the market, hence the Fed would have to pledge to open-ended purchases to really have an impact. Thirdly, interest rates are already at record lows in the US. Lastly, QE1 and 2 invoked the ire of emerging markets who felt the US was staging a currency war and trying to de-base the dollar while pushing up inflation around the globe. If the Fed wants to avoid another diplomatic nightmare then it might keep its hand well away from the printing presses later today.

The pitfalls of more QE

The markets don't seem to pay much attention to the minutia of diplomatic relations and the recovery in the euro and global stock markets after last week's rout could be investors pricing in the prospect of more Fed action. However, the gold price has proven to be a bit of a leading indicator of late. Rather than recover and rally on the back of today's broad-based weakness in the greenback, it has fallen quite sharply. In recent sessions EURUSD and gold have moved in roughly the same direction, not so today. Typically the gold price rallies when the Fed does QE because1, it is perceived as a hedge against Fed-induced inflation and 2, QE tends to weaken the dollar, which is gold positive since the yellow metal is priced in dollars. So is the gold price telling us that there is a bigger chance than some think that the Fed won't do more QE today? Or that inflation pressures are not really a concern especially after inflation in the UK fell last month? All will be revealed this evening, until then we expect some choppy consolidation in the markets as we wait for the announcement.

There is also some expectation the Fed could do more Operation Twist (where by it changes the duration of its Treasury holdings by selling short-term debt and buying long-term debt). The current Operation Twist expires this month so there is a good argument for the Fed to expand this and keep the status quo, thus throwing a bone to the market. However, we don't think the markets would react well to an extension of Twist for a couple of reasons: 1, it doesn't expand the size of the Fed's balance sheet so there is no fresh liquidity being pumped back into the economy. 2, the Fed could have exhausted Twist already as there is less than $300bn of Treasuries remaining with a life span of 3-years or less so it may not be big enough to have an impact on the market. Thus, the Fed needs to choose what it wants to do carefully: play good guy or bad guy in the markets. Either way, its decision will be a major driver of markets in the medium term, in our view.

BOE gets closer to QE

Easier to predict is the Bank of England. The minutes of its latest meeting were dovish, as expected. At his speech at the Mansion House dinner last week Governor Mervyn King basically spelt out that the Bank will do more QE in the short-term. The minutes backed this up as 4 out of 9 members voted for more QE at the meeting earlier this month, which was a close call to remain on hold. The question now is will the Bank do GBP50 or GBP75 bn of more Gilt purchases? The BOE comes up against the same problems as the Fed as more attempts at QE tend to dilute its effect. Thus, if the Bank wants to get an effect it may well choose to boost QE by GBP75 bn when it meets on 5th July.

A coalition is formed!

Greece is likely to swear in New Democracy's Samaras today as PM as the pro-bailout parties are likely to come together to form a democracy. Compared to all the Fed speculation and Spanish bond yields surging to euro-era highs earlier this week, the Greek election seem to be remarkably calm affair. However, with the radical left anti-bailout Syriza party set to be a formidable force in opposition the prospect of Greece leaving the Eurozone remains on the table. After yesterday's speculation that the EU would loosen Greece's strict austerity targets, German officials have come out to temper expectation saying that reforms are a condition of further aid to Greece. We would expect this type of rhetoric to continue. Although it is likely that the goal posts will be moved to help Greece as it goes through a 5th year of recession, Germany can't be seen as giving into the Greeks and spreading moral hazard across the currency bloc.

Market Moves

Ahead today, all eyes will be on whether the markets will continue to rally into the Fed announcement or if risk assets will follow gold lower. EURUSD is in the middle of its recent range. If the Fed does do more QE we could see the cross break above 1.2750 (the high from Sunday night) and target 1.2825 then 1.29. If the Fed doesn't do QE expect a sharp recovery in the dollar that could send EURUSD back to 1.2625 then to 1.2525 - the 21-day sma and major support zone. Likewise, a Fed on hold could take AUDUSD and NZDUSD off their recent highs. Support for AUDUSD lies at 1.0125 - the base of the Ichimoku cloud. 0.7900 is key support for NZDUSD.

EURGBP is also worth watching. This is a pure play on BOE QE expectations in our view, especially as it seems the BOE is closer to pulling the trigger on more QE than the ECB, which may be positive for this pair. If it can close above 0.8080 - the base of the daily Ichimoku cloud - it opens the way to further gains towards 0.8150.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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