QElusional?

  on

After the positive effects of the Greek election fade, markets will shift focus toward the Federal Reserve announcement scheduled for Wednesday. Despite injecting more than 2.3 trillion dollars into the financial system and shifting 400 billion dollars into long-term debt since November 2008, policymakers are facing an increasingly complex set of challenges.

Brazil, India and China are all slowing rapidly, while the European common currency teeters on the edge of the abyss.
In relative terms, the US economy appears to be a rock in a sea of troubles.

But in absolute terms, it is adrift in a roiling ocean of uncertainty, in danger of being pulled under.

International

After a strongly positive first quarter, activity has slowed dramatically. Manufacturing output and retail sales have hit a wall and job creation has stalled. Perhaps more importantly, credit conditions have begun to tighten once more: share prices have fallen, lending has contracted, and market spreads have widened.

All of these factors indicate that the flow of money into the real economy is slowing - and they are driving investors to expect that the Federal Reserve will announce additional stimulus efforts this week.

The Bank could launch the QE3, and begin another round of bond purchases. It might choose to do nothing. Or it may conduct a short-term extension of the portfolio maturity programme it began last year. Operation Twist - the 400 billion dollar effort to twist the yield curve by selling more short-term securities while buying longer-term ones - is due to expire at the end of June.

A slightly modified version of the latter is most likely.

Benchmark interest rates are already near the lowest levels ever recorded, meaning that additional purchases would have a relatively minor effect on the cost of borrowing. They would also unquestionably provoke a political backlash, potentially damaging the Fed's credibility.

Doing nothing would prove an immense disappointment for the markets, sending asset prices downward and interest rates upward. This would have a real-world effect, by hurting economic sentiment and making businesses more cautious about investing.

By selling short-term instruments and using the proceeds to purchase long-dated mortgage-back securities, policymakers could provide stimulus across the yield curve while also targeting the housing market directly. Injecting capital into the housing market might help to boost retail spending without contributing to a dangerous rise in inflationary pressures - and neatly sidestep political opposition at the same time.

What does this mean for the currency markets?

The previous quantitative easing programmes kicked off a two-year rally in commodity bloc currencies, while dragging the value of the US dollar downward. Commodities skyrocketed on the belief that emerging market demand would continue to increase.

Cheap Federal Reserve money flowed into the financial markets, bypassing the real economy.

Today, this story is not as compelling.

This means that we should not expect a prolonged rally in asset prices in the event that the Fed does choose to act. For the markets, the law of diminishing returns has kicked in.

But this has a positive corollary. In the absence of an international outlet, central bank money is more likely to be put to use closer to home, in the United States itself. If this is the case, we may see the Fed's actions gaining more traction than we've seen over the past few years. The definition of insanity may not hold in this case. Here's hoping.

Have a great week - and happy trading!

International

Join the Discussion