Anticipating the US Dollar’s Response to QE2

Another election day has come and gone, and I for one am happy to see it over with, as I hate all of the political ads and phone calls during the heat of the election cycle. My wife and I went to the polling place together after dinner last night and the workers said the turnout was a bit better than usual for a mid-term election. The currency markets were a bit mixed yesterday, as the higher yielding currencies did well versus the US dollar ahead of today’s FOMC announcement. The euro (EUR) also moved up a bit in spite of renewed worries about sovereign debt. More on the currency markets in a bit, but I will start today’s Pfennig with the two big stories of the day.

The elections held little surprises with Republicans taking back control of the house and narrowing the Democratic majority in the Senate. The election results will put some pressure on President Obama to work across the aisle, as he will now have to compromise in order to get anything passed. The elections definitely showed the dissatisfaction with the job the President and Congress have done to put us back on a growth path

The Tea Party definitely shook things up in the primaries, but the results in the general election were a bit more mixed. Rand Paul was the most notable Tea Party winner, and he had a lot to say after his election. “Tonight, there’s a Tea Party tidal wave and we’re sending a message to lawmakers in Washington,” Paul said in his victory speech. “It’s a message on fiscal sanity, it’s a message on limited constitutional government and balanced budgets.” I don’t think the new Senator is going to get along too well with our Fed Head as the FOMC prepares to announce another round of stimulus spending. The Kentucky Senator elect has been a very vocal critic of the Fed and recently called them out on imposing what is the sneakiest tax of all – INFLATION.

The elections will certainly dominate the news for a while, but the currency markets have already shifted their focus on the FOMC announcement later this morning. Traders aren’t looking at what the Fed will do with interest rates, as there is little room for Ben to lower them any further. No, instead they will be focused on an expected announcement of a second round of stimulus (QE II). Bernanke and his compatriots feel the need to push more liquidity into the markets in order to try and stimulate some growth. But many economists question just how much of an impact another $500 billion will have. After all, how much lower can bond yields go? So what do they want to accomplish with all of this new stimulus? Will another 0.25% drop in interest rates really cause companies and individuals to decide to go out and borrow and spend again? On an individual level, I think anyone who can qualify for a loan has probably already taken advantage of these record low rates. And businesses are not going to borrow and expand until they feel more confident about the future direction of the economy. Does another $500 billion of government spending increase confidence in the US economic recovery? Certainly not for the longer term, and again I even question the short-term impact.

But the FOMC seems to have made their decision already, and the markets are looking for $500 billion of additional bond buying this afternoon. If the announcement is less than the $500 billion everyone is counting on we could see a bit of a rally in the dollar. The dollar could also find support if more than one Federal Reserve policy maker objects to resuming the asset purchases. The announcement will also be studied to see if it leaves the door open for future increases or decreases of the stimulus amount. It could be a rather exciting afternoon in the currency markets. The Fed announcement was definitely on the mind of Bond Guru Bill Gross of PIMCO who had this to say yesterday in a Reuters interview:

I think a 20 percent decline in the dollar is possible, and the pace of the currency’s decline is also an important consideration for investors. When a central bank prints trillions of dollars of checks, which is not necessarily what (a second round of quantitative easing) will do in terms of the amount, but if it gets into that territory – that is a debasement of the dollar in terms of the supply of dollars on a global basis. QE II not only produces more dollars but it also lowers the yield that investors earn on them and makes foreigners, which is the key link to the currencies, it makes foreigners less willing to hold dollars in currency form or at current prices.

Sounds like Bill read my Pfennig yesterday! Or more likely this is the logical conclusion you have to make with a government who is set on introducing what will likely be another trillion dollars of liquidity into the markets. QE2 will not be good for the dollar, not in the short-term or even the longer term. Gross went on during the interview to suggest US investors look outside our borders for investments, as the US economy will continue to show sluggish growth in relation to many of the developing countries across the globe.

Chuck sent me an article yesterday from Ambrose Evans-Pritchard writing in the UK Telegraph. He was talking about the longer-term impacts of QE2 on the future of the dollar as the global reserve currency:

The Fed’s “QE2” risks accelerating the demise of the dollar-based currency system, perhaps leading to an unstable tripod with the euro and yuan, or a hybrid gold standard, or a multi-metal “bancor” along lines proposed by John Maynard Keynes in the 1940s.

China’s commerce ministry fired an irate broadside against Washington on Monday. “The continued and drastic US dollar depreciation recently has led countries including Japan, South Korea, and Thailand to intervene in the currency market, intensifying a ‘currency war’. In the mid-term, the US dollar will continue to weaken and gaming between major currencies will escalate,” it said.

David Bloom, currency chief at HSBC, said the root problem is lack of underlying demand in the global economy, leaving Western economies trapped near stalling speed. “There are no policy levers left. Countries are having to tighten fiscal policy, and interest rates are already near zero. The last resort is a weaker currency, so everybody is trying to do it,” he said.

Again, I make the point that I’ve made a couple of times now… David Bloom says, “So everybody is trying to do it”… I beg to differ! If you want to make your currency weaker, you don’t raise the interest rate! Countries like: Australia, Brazil, Norway, Sweden, Canada, China and India, have raised rates this year… Sure doesn’t look like they want weaker currencies now does it?

Chuck is right… If Australia, India, Canada, and Brazil were looking for weaker currencies they sure aren’t doing a very good job! Aussie (AUD) and Canada (CAD) both moved back to trade at parity versus the US dollar overnight and the Brazilian real (BRL) and Indian rupee (INR) continue to move higher versus the US dollar. So while the US, Japan – and to a lesser extent Europe – are all in a race to weaken their currencies, you can’t say that everyone is doing it.

The pound sterling (GBP) was surprisingly one of the best performing currencies versus the US dollar overnight with a more than 1-cent move. The Bank of England will make their interest rate announcement tomorrow morning, and recent data suggests they will not announce additional stimulus measures. The UK economy expanded 0.8% in the third quarter, twice the pace predicted by economists, and September’s inflation rate of 3.1% exceeded the government’s upper limit. Data released earlier this morning showed that UK services growth unexpectedly rose in October to the highest level in four months. This stronger data has some economists now predicting an interest rate increase by the BOE, but I believe they will hold off until 2011.

The recent dollar weakness, and the rising likelihood of a protracted slide for the greenback has caught the attention of German Chancellor Angela Merkel. The German economy is dependent on exports, and a stronger euro threatens the nascent recovery in Europe; so Merkel is doing what she can to remind the markets of all of the sovereign debt problems that still exist. Europe’s manufacturing industries expanded at a faster pace in October than initially estimated, and this manufacturing strength was led as always by Germany. Merkel has been pushing the EU to reshape the debt and deficit rules for the euro, as she tries to assure German taxpayers that they will not be on the hook for bailing out other European countries. This tough talk by Merkel regarding the weaker EU members has the intended consequence of weakening the euro, which is helpful to the German economic recovery.

But the FOMC will not help Merkel’s effort to push the euro lower, as their expected QE2 announcement this afternoon will probably cause a rally in the euro. But the ECB will have the last word as they will make their interest rate decision 16 hours after the FOMC announcement. And the ECB could try to quash any euro rally with a stimulus announcement of their own. Merkel and the ECB might be successful in shifting the focus of the currency markets away from the QE2, but technical analysis suggests the euro will continue to extend its gains. The euro is predicted to rise to a high of $1.44 should the currency close above major resistance at 1.4004 according to technical analysts at Forecast Pte.

The Canadian dollar gained for a fourth day and is again trading near parity with the US dollar. The Canadian dollar is benefiting from their commodity-based economy as oil and precious metals continue to appreciate. The Bank of Canada Governor Mark Carney is not going to follow Ben Bernanke in a second attempt at stimulus. In fact, Canada’s central bank will reduce the amount of bonds available to securities dealers, pulling back some of the liquidity it pushed into the markets during 2008 and 2009. Canada’s central bank has, in my opinion, handled the financial crisis much better than our FOMC. Granted, they have the additional advantage of a wealth of commodities, but their leaders did a great job of pushing liquidity into the markets when they needed it, and are now pulling that liquidity back out. Strong commodity prices and the possibility of an increase in interest rates should keep the loonie well bid versus the US dollar.

The unexpected increase by the RBA pushed the Aussie dollar to one of the best performances of the week. And Governor Glenn Stevens isn’t doing anything to try and stop the Australian dollar’s appreciation. The “risk of inflation rising” remains, according to Stevens. It is clear that the RBA will continue to push interest rates higher, and with the BOJ and the FOMC keeping rates near zero, the Australian dollar should continue to be a good performer.

Recap: Elections in the US put the Republicans in control of the House, and narrowed the Democrats’ advantage in the Senate. Ben Bernanke will likely announce another round of stimulus, and that has Bill Gross joining us in warning investors of the results: a weaker dollar! Pound sterling rallied versus the US dollar as the BOE is likely to hold off from announcing additional stimulus, and the ECB may be forced to join the US in order to keep the euro from rising too quickly. And finally, the Canadian and Australian dollars look to hold their strength versus the US dollar.

Chris Gaffney
for The Daily Reckoning