US Dollar Trades in a Tight Range in Anticipation of QE3

The dollar remained in pretty tight ranges yesterday as currency traders wait to see what Ben Bernanke and the rest of the FOMC will come up with. The markets are counting on a big stimulus project to be announced, with the Dow hitting 5-year highs. Yesterday’s German court ruling continued to support the euro (EUR) and a fairly surprising Dutch election result also calmed fears. Labor unrest in South Africa had the rand (ZAR) trading lower and central banks in both New Zealand and Switzerland decided to keep rates unchanged.

But the big event driving the markets yesterday and this morning is the expected announcement of another quantitative easing program by the Federal Open Markets Committee. Ben Bernanke will hold a press conference just after noon today to explain what measures he and the rest of the FOMC have decided to enact in hopes of stimulating the US economy. Chairman Bernanke has reiterated his ‘grave’ concerns regarding the stubbornly high unemployment rate here in the US, and many are now expecting him to announce an ECB like unlimited bond buying program.

I don’t think that is what the US economy needs right now. It worked for the ECB, but what is good for them is not necessarily what is needed on this side of the pond. The two central banks are facing much different problems, and therefore need very different solutions. The ECB was facing constant questions regarding the future of their single currency. They were also battling ‘bond vigilantes’ who moved from one country to the next running interest rates up and then profiting from the fears of a euro collapse. The ECB had to take bold action to combat these bond traders, and unlimited buying of bonds certainly seemed to scare off most of those selling bonds short. The ECB’s has definitely had the desired effect, stabilizing the bond markets and giving countries a little more time to work through their debt problems. It has also pushed the euro higher as the risks of a full blown euro breakup have been reduced.

Ben Bernanke and the FOMC face a very different problem. The Fed has taken it upon themselves to try and revive the labor market. In the past the Fed had a single mandate: to keep prices steady by keeping inflation at bay. But recently they accepted the additional responsibility of keeping the labor markets at maximum employment. The problem with this new dual mandate is the Fed can only hire so many employees, and any other attempts at directly impacting the labor picture are untested. Low interest rates seemed to be a good idea, as the lower cost of funding should create an inviting environment for companies looking to spend on new factories and equipment. In the past these lower rates also stimulated consumers to add more ‘cheap’ debt enabling them to go out and spend. But the credit crisis and resulting plunge in housing prices and consumer net worth have taken away most of the projected benefits of these lower rates.

That is why I question another round of quantitative easing. Just what do Bernanke and the rest of the voting members think they are going to accomplish by pumping unlimited cash into the bond markets? The 10- and 30-year interest rates are already near record lows, does he think another 10 or 20 basis points is going to make much of a difference? The ECB bond buying had a specific goal; to lower rates from what they considered unjustifiably high levels. In contrast, the FOMC is trying to force rates which are already abnormally low even lower. I just don’t think another round of QE, and the accumulation of new debt which will accompany it is justified.

But I guess if Bernanke is measuring the success of his stimulus programs by the stock market, they have been a huge success. As I mentioned in the opening paragraph, the Dow Jones average is trading back at levels it was at prior to the credit crisis. The last time the stock markets were at these levels was December of 2007. But higher stock prices obviously doesn’t translate to higher employment. Companies are returning to profitability, and their stock prices reflect this. But their workers aren’t participating, and the middle class continues to get squeezed.

Probably took that line of thought a bit too far off course, so let me return to the currency markets. The Fed stimulus expectations sent the dollar lower through the first part of the week, but it stayed in a fairly narrow range yesterday as some started to worry that Bernanke wasn’t going to be able to sufficiently deliver on all of the hype surrounding QE3. I am still confident the FOMC will announce some sort of bond buying program, but it may not duplicate the bold ‘unlimited’ purchase plan enacted by the ECB. The size of the program announced will likely determine the direction of the dollar. A smaller target for bond purchases would probably cause the dollar to rebound, but a larger program would send the dollar lower. Extremes on either side would have an even more dramatic impact on the greenback.

The euro remained above $1.29 after the German court dismissed the challenges to the funding of the ESM. The ruling was a victory for German Chancellor Angela Merkel who has emerged from the euro-crisis as a very impressive leader. Some would also call her an excellent manipulator of the markets, as she has seemed to get them to follow in any direction she wants to take them. For now the euro is looking entrenched in a new higher range, but I’m fairly certain we will see more volatility as Greece and the other weaker EU members try to work through their debt problems.

Greek prime minister Antonis Samaras was again unable to get his coalition partners to agree on plans to reduce spending. These austerity measures are the key to receiving another round of aid, so Samaras must get his ruling partners to agree or they risk throwing their rescue back into crisis mode. It sure looks like things are going to remain interesting in Europe, and particularly in Greece.

The Danish krona is pegged to the euro, and elections in Demark were seen by some to be a vote of confidence in the EU. Voters in Denmark rejected hard-line left and right parties calling for the withdrawal from the EU, and early results suggested the prime minister would remain in power. Many of the WorldMarket clients have invested in DKK 3-month CDs with the thought that Denmark will eventually break the peg. The pressure on the DKK/Euro peg has been reduced with these election results, but as I mentioned earlier, we have not seen the end of the European debt problems. This peg may yet be tested.

The Swiss national bank pledged to uphold its peg to the euro in an announcement following their meeting yesterday. Like the ECB, the SNB pledged ‘unlimited quantities’ of purchases in an effort to keep the value of the franc (CHF) from moving through their ceiling of 1.20 francs per euro. The central bank also left its benchmark interest rate at zero, as expected. The defense of the euro peg has led the SNB to increase their foreign currency reserves 64% to 418 billion francs ($446 billion). These holdings now equate to about 73% of GDP, an unsustainable level. The majority of these reserves are held in euros, as the SNB has had to exchange their Swiss francs for euros in order to keep the value pegged. Currency traders expect the Swiss franc to appreciate dramatically if/when the SNB would drop the peg, and the central bank obviously wants to end any speculation with their use of the word ‘unlimited’ in their defense.

South Africa’s rand weakened the most out of the major currencies yesterday after continued labor strikes at mines. Workers at two different mines were either on strike or staying away from work following conflicts which left 44 dead last month. The Rand remains in a trading range of 8.55-8.06, which it has been since the end of May.

The New Zealand central bank kept interest rates unchanged and suggested they would remain at current levels through mid-2013. Reserve Bank Governor Alan Bollard worried to reporters about the strength of New Zealand’s trading partners. This was the last meeting for Bollard, who is stepping down later this month after spending 10 years at the head of the New Zealand central bank. With the coming change in leadership, any projection of future interest rate moves should be discounted as the new leader may decide to take a different approach. But the accompanying monetary policy statement definitely sounded a cautionary tone with regard to the New Zealand economy. “Headwinds for the economic outlook are still evident,” according to today’s report released by the RBNZ. “Domestically, the unemployment rate remains elevated.” Slow domestic growth and higher currency prices are keeping inflation in check, and the central bank thinks rates will remain where they are for most of 2013.

Gold dropped a bit yesterday as investors anxiously awaited the decision by the Fed. Gold jumped over 2.4% in the past 10 days so a pause in the price movements is to be expected. Like the direction of the dollar, the movement of the price of gold will be determined by the size of the stimulus announced today by the Fed. If the stimulus is large or unlimited, gold should rally. But if the stimulus is smaller than expected, or is pushed off until the next meeting, we could see gold give back some of its recent gains.

To recap: The dollar stayed in fairly narrow ranges yesterday as we await a stimulus decision by the FOMC. I question the need for more bond buying here in the US, and compare our situation to that faced by the ECB. The euro remained well bid after the German court ruling and a good election result in Denmark. The Swiss national bank left rates unchanged, as did the RBNZ in what was Bollard’s last meeting. And gold dropped a bit yesterday, pausing before the FOMC decision.

Chris Gaffney
for The Daily Reckoning