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FOMC Preview: Why More QE May Not be so Bad for the Dollar

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By Kathy Lien, Director of Currency Research at GFT

The general belief in the market is that more Quantitative Easing or stimulus is bearish for the U.S. dollar because it lowers U.S. yields and erodes the value of the greenback. Although this may be true in the long term, in the short term, the dollar could respond positively to more QE. With only 24 hours to go before the FOMC announcement, investors around the world are sitting at the edge of their seats waiting for the Federal Reserve's monetary policy decision. The sell-off in the U.S. dollar today and rally in equities suggests that investors are already squaring long dollar positions and laying on their pre-QE3 trades. Having expanded this month's meeting from one to two days, the central bank has set the market up for a big announcement. Thanks to their advance notice, economists and investors have had plenty of time to consider what the Fed will do and the consensus view is that the central bank will opt for Operation Twist, a monetary policy tool used back in the 1960s.

For anyone hoping that Bernanke will ride in like a white knight carrying a cart load of stimulus, the risk of disappointment is greater than the risk of a surprise because even the central bank has warned that their ability to stimulate the economy is limited. With the U.S. economy experiencing zero employment and retail sales growth in the month of August, desperate times call for desperate measures. The Federal Reserve has been preparing the market for more stimulus in some form or another since the last FOMC meeting and in doing so, they have given investors an opportunity to discount a move, which means if they want a strong and positive reaction from the markets, they need to overwhelm and not underwhelm. Operation Twist has been talked about extensively as the option the Fed will choose to stimulate the economy but the problem is that it has already been priced in by investors and may therefore elicit nothing more than a weak response, wasting the central bank's efforts. The same is true for lowering the interest rate on reserves. Operation Twist underwhelm the market and may even trigger a buy the rumor sell the news type of reaction. If the Fed wants to surprise the market and trigger a sharp rally in currencies and equities, they will need to be more aggressive which means combining different options and perhaps taking an even bolder step by tying interest rates to a piece of economic data like the unemployment rate, an idea suggested by Fed President Evans.

1) Doing nothing

2) Funding the purchase of long term Treasuries with the sale of short term ones (Operation Twist)

3) Lowering the interest rate on reserves

4) Announcing another round of asset purchases

5) Tying interest rates to economic data (like the unemployment rate)

Doing nothing would be the worse thing that the Federal Reserve could do and would most certainly send currencies and equities plunging. The reasons why the central bank could do nothing are because inflation is high and every effort so far has failed to stimulate growth. Unfortunately inaction is inexcusable because preventing recession is just as important as promoting growth and the U.S. economy stands the risk of falling back into recession without more support from the Fed. Just because no press conference has been scheduled does not preclude a major policy change. Fielding questions from reporters and giving Bernanke an opportunity to shoot himself in the foot could end up being more counterproductive. Operation Twist is the step that most investors and economists believe the central bank will take but the success of Operation Twist is also debatable. It flattened the yield curve in the 1960s but only lowered long term Treasury yields by approximately 15bp, an amount that was highly statistically significant but moderate according to the San Francisco Federal Reserve. A 15bp reduction in LT yields is often likened to a 1 percent rate cut but ultra low rates has done little to encourage corporate spending and hiring. Faced with a deep recession and a persistent international balance of payments deficit, the Kennedy Administration felt that Operation Twist would be a grand-sweeping solution for both problems. By buying long term Treasuries and actively lowering long term yields, they hoped to encourage business investment and housing demand with lower long term yields and attract foreign investment demand with higher short term yields. The difference between the 1960 version of Operation Twist and the 2011 version is that the program was only $8 Billion in the 1960s - Bernanke's version will be much larger. However if the Fed really wants to send a strong message to the market, they need to do more and a combination of different tools appears to be their best option. Hopefully they will overwhelm and not just meet the market's expectations.

The reason why the market is so dead set on more stimulus is because the recovery in the U.S. has come to a screeching halt and everyone including the Fed agrees that the economy desperately needs help. The following table shows how the economy has performed since the last monetary policy meeting and we can see widespread deterioration. Aside from zero consumer spending and employment growth, the housing market and manufacturing sector weakened. The service sector improved slightly and inflation increased but along with the volatility in the financial markets, the central bank has more reason to be concerned than optimistic which is why they will be ignoring the price pressures and charging forward with more stimulus.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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