No Change to QE2

As I turn on the TVs here on the trading floor they all have pictures of the damaged nuclear power plant in Japan. Apparently there was another explosion, and fears of a major radiation leak are increasing. The news has currency investors in Europe running back to the US dollar and abandoning “riskier” assets. The yen (JPY) is also gaining this morning after trading lower through most of Monday’s trading day. We have a lot to cover this morning, so I will jump right in.

Today the FOMC will hold its March meeting and announce no change in interest rates nor any change to QE2. These are pretty much guarantees, and the markets have long priced in this non-action by the Fed. But traders will be focusing on the speeches following the announcement to try and determine if there is any change in bias at the Fed. While the Fed is “officially” supposed to balance growth with inflation, all indications are that the former is much more important to Chairman Bernanke than the latter. The threat of a faltering recovery, and the subsequent drop in equity prices, appears to be a bigger risk to this Fed than inflation.

I find The 5 Min Forecast, which is a publication of our friends over at Agora Financial, a great daily read. It is always full of great information laden with a good deal of wit. Yesterday’s 5 contained the following, which illustrates just how out of touch some of our Fed heads have become:

New York Fed chief William Dudley – a 21-year vet of Goldman Sachs – stepped out of his bubble to explain Fed policy to real people in Queens.

It might not have been the first time Dudley attempted to gain the trust of the hoi polloi, but we’re pretty sure it’ll be the last. The details here were reported widely. We divined the scene from a Reuters report.

First Dudley swore up and down that inflation was no problem. “When was the last time, sir,” came a reply from the audience, “that you went grocery shopping?”

Dudley boldly proceeded to explain the concept of “core CPI” – the cost-of-living measure designed for people who don’t eat or consume energy. Heh, we know firsthand how well that goes over…

Then in a brilliant stroke, he pointed to Apple’s shiny new iPad 2 to illustrate his point. “Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,” he gamely explained. “You have to look at the prices of all things.”

“I can’t eat an iPad,” someone yelled from the crowd.

With the Fed ignoring inflation, interest rate expectations are now favoring investments in the euro (EUR). The FOMC will continue to keep rates near zero and will likely increase the amount of liquidity they are pumping into the markets. Currency traders usually have a longer-term outlook, and inflation is a killer of currencies, which is bad news for the US dollar. I read an excellent column online in this week’s Economist titled “Ahead of the Fed.” Here is just a portion of the column, written by R.A.:

The pendulum seems to have swung decisively in Europe, where the European Central Bank recently signaled its intent to increase its benchmark interest rate in the near future. The hawkish contingent within the Bank of England has also gained strength lately. But while some Fed governors have been vocally critical of recent Fed policy, the FOMC remains more concerned about downside risks to prices and activity than its peers. This is due in part to the Fed’s focus on core inflation, and to the simple fact that headline price increases in America have not been as large as in Europe and Britain. But as commodity prices, and oil prices especially, move upward, the Fed’s posture faces increasing criticism.

The column goes on to suggest that the Fed will likely continue their dovish tone, and the asset purchases of QE2. As readers know, Chuck has gone out on a limb to suggest we might even see a QE3! While the equity markets may cheer all of this liquidity, I fear the debt that is being created will eventually sink the US. A more hawkish tone is just what I think the Fed should sound, but unfortunately Chairman Bernanke and his compatriots seem to be taking a shorter-term view.

I received a lot of nice notes regarding yesterday’s Pfennig and my discussion of the Japanese earthquake and its implications for the currency markets. As usual, there were also some that disagreed, but I truly enjoy reading all comments, good and bad. Last night, while searching for some good Pfennig Pfodder, I came across a research note put out by BNP Paribas that confirmed what I have been thinking. The note said investors should buy the euro against the yen on bets the EU’s plan will calm the debt crisis while Japanese officials will fight any gains in the yen. “While we expect continued pressure on the dollar yen on repatriation flows, it seems likely that the Bank of Japan will be far more aggressive in its approach,” analysts at BNP wrote. “We look for opportunities to go long euro-yen over the medium term.” That is currency speak for buy euros and sell yen.

The euro has been a bit volatile, moving higher throughout yesterday after the EU agreement but then selling off overnight with the explosions in Japan. As I stated yesterday, the EU went ahead and expanded the scope of the rescue fund; but the agreement leaves most of the financial burden of the crisis right where it should be, with the troubled states. Although many (including members of the ECB) would have liked to see the EU take on a larger role in the bailout, the markets seem to agree that the troubled states are going to have to make the necessary adjustments in order to pull themselves out of their debt problems. The single bone the EU threw to the troubled states was a reduction in the borrowing costs to Greece.

Chuck and I have had numerous conversations regarding the trouble in Europe, and reviewed several of the possible outcomes. Neither of us have ever believed that the euro would disappear. Germany and France have too much to lose if the euro would “go away.” But there is a very good possibility that some of the weaker countries that are part of the euro will have to exit the single currency. This would actually benefit all parties involved, as the euro would be left with the fundamentally stronger economies, and the countries that exit would be able to devalue their currencies to help alleviate their debt problems. Perhaps this is why the markets are encouraged by the EU’s refusal to take on more of the troubled countries’ debts.

The ECB, on the other hand, is not so excited by the EU’s news. The new pact that was reached leaves the ECB as the primary backstop in the European bond markets. Trichet and his cohorts had wanted to begin to execute their exit strategy, and hoped the EU would take their place and begin purchasing sovereign debt in the open market. But that didn’t happen, and the ECB must now decide between their desire to keep borrowing costs down in the PIGS and their stated mandate to keep down inflation. Rhetoric following their last meeting suggests the ECB has regained their traditionally hawkish tone and will probably begin raising rates in the near future. The catastrophe in Japan, and its negative impact on oil prices, may delay a move higher, but all indications are that an increase in European interest rates is on the near-term horizon.

The Swiss franc (CHF) has been a benefactor of the nuclear fears over in Japan. The franc is still seen by many as the safest of safe haven currencies, and is the only currency besides the Japanese yen that is up versus the US dollar over the past 24 hours. Surprisingly, the precious metals are off this morning. Gold is one of the best “uncertainty hedges” out there, so the $20 sell-off in the price of the shiny metal is odd. But even with this drop, gold is still hanging in above the $1,400 level and remains in the fairly tight range it has established since the end of February.

Both the Australian (AUD) and New Zealand dollars (NZD) were lower as Japanese investors continued to pull funds out of these higher yielding currencies. An astute Pfennig reader pointed out that the repatriation of Japanese yen is forcing carry trade reversals, which will bring down the value of both the Aussie and New Zealand dollars in the near term. But this reversal is only temporary, and while Japanese investors will continue to be pre-occupied with the rebuilding efforts, I believe international investors will return to Australia. After all, Reserve Bank of Australia Governor Glen Stevens has led the world in raising interest rates after the global recession. Australian rates are now among the highest in the developed world, and commodity inflation continues to keep the pressure on for even more rate increases.

The Canadian dollar (CAD), which was increasing in lockstep with the price of oil, declined versus the US dollar. The news that Japan was shutting down a number of factories combined with a bad bit of economic news to drive the loonie lower. The bad economic news came in the form of a weaker-than-expected capacity utilization number. Canadian industrial companies are not using as much of their capacity as was predicted, which furthered the argument that Canadian interest rates will probably remain steady for some time.

One country where interest rates will not be remaining steady is India, which will likely be raising rates later this week. A report released yesterday showed that India’s inflation unexpectedly surged in February. The wholesale price index rose 8.31% from a year earlier after an 8.23 percent jump in January. The Reserve Bank of India will meet this Thursday and will likely vote to move rates higher.

To recap… Nuclear fallout threatens Japan and the currency traders move back to the “safe havens.” Today’s FOMC decision is likely to be a non-event while the ECB is set to take a hawkish tone. Aussie dollars and the kiwi are sold like funnel cakes at the county fair, and inflation in India looks to push rates higher.

Chris Gaffney
for The Daily Reckoning

The Daily Reckoning