Possible End to QE2 Pushes the US Dollar Higher

Good Day… Mike did a great job last week, didn’t he? I read over all of the Pfennigs yesterday to try and get caught up on things, and it sure sounded like an exciting week. A cooling of the reactors at the damaged nuclear plant in Japan and NATO military success in Libya have calmed the markets, and currency traders have begun to move back into the “risk” trades. This will be positive for the high-yielding commodity-based currencies, and should be negative for those currencies that were purchased as “safe havens.”

St. Louis Federal Reserve President James Bullard dominated this weekend’s news with a suggestion that the Fed should consider exiting QE2 prior to spending the full $600 billion that was approved for the purchase of US Treasury securities. Apparently Bullard feels that the 3% GDP reported for the fourth quarter on Friday is strong enough to prompt an early exit from round two of the quantitative easing program. “The economy is looking pretty good,” Bullard said to reporters in France on Saturday. “It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short,” he said. QE2 is scheduled to continue through June, and many (including myself) still think there is a good chance we see a third round of easing before the end of the year. Chairman Bernanke has not shown any desire to end the program early, and continues to be worried about the “jobless” recovery here in the US.

But the dollar bulls liked what they heard from Bullard, and the dollar is up slightly in European trading. The reason for the dollar strength goes back to supply and demand. The Fed has been pumping dollars into the markets with their purchase of US Treasuries. So the currency markets have already priced in the additional $600 billion of supply, but if the Fed stops the program before placing all of these funds into the markets, there would be less US currency flooding the markets and therefore the value of each dollar should rise. An early exit by the Fed from the bond purchases would also move rates higher, decreasing the interest rate differential, which has been widening recently. The dollar also got some help from predictions that this morning’s Personal Spending data will show that US consumers are increasing their purchases. Personal spending is expected to have increased 0.5% in February, and Personal income is expected to have increased slightly less at 0.4%. We will also see pending home sales numbers for February, which will probably be disappointing.

The rest of the week will be pretty slow as far as economic data is concerned, with just the consumer confidence and CaseShiller home price index tomorrow and Challenger jobs data on Wednesday. Thursday will bring our usual weekly jobs numbers along with Factory orders for February. Friday will be the big data day, with the release of the employment data for March along with the ISM Manufacturing and Vehicle sales numbers. With no real data released until Friday here in the US, markets will continue to look for direction from Europe and the Middle East.

The euro (EUR) is trading off a bit in early trading after German Chancellor Angela Merkel’s Christian Democrats were defeated in a regional election. Merkel has been a strong force in the EU’s navigation through the treacherous waters of the sovereign debt crisis, and any indication that she could be losing her grip on power in Germany is bad news for the euro. Mike wrote about Portugal’s problems last week, and the ratings agencies are “piling on” as usual. S&P followed Fitch in cutting Portugal’s credit rating late last week and warned that further downgrades are possible as early as this week. Portugal’s President still hasn’t asked for help from the EU, and is convinced he will be able to get the country’s three biggest political parties to agree on budget cuts in order to meet the government’s deficit targets. The Portuguese government has set a target for a budget deficit of 4.6% of GDP in 2011 and aims to reach the EU limit of 3% in 2012. As Mike pointed out, Portugal is just a small piece of the European picture, but it shows that this sovereign debt problem has some real legs, and will continue to cast a shadow on the euro.

We will get a clear picture of how the markets feel about the EU debt crisis this week, as Italy plans to sell 21.5 billion euros of debt. Italy is Europe’s most indebted country in nominal terms with 1.8 trillion euros of debt. But Italy didn’t have a housing and borrowing fueled boom, so the Italian banks are in better shape than their competitors in Ireland and Greece. The debt auction is expected to go well, and should put a floor on any euro fallout from the Portugal downgrades.

The pound (GBP) continued to decline on Friday, and is off further in this morning’s European trading. The pound fell after a report showed that UK business confidence is the weakest in two years. As Mike reported last week, minutes from the last BOE meeting suggests that rates will remain low. Data to be released tomorrow may further weaken the pound, as it is expected to confirm that the UK economy shrank more than initially estimated in the fourth quarter. Government austerity measures and rising fuel prices are to blame for the negative confidence.

The commodity currencies of Canada (CAD), Australia (AUD), and New Zealand (NZD) were among the best performers over the weekend as investors felt more confidence in the global economic recovery. The Canadian dollar gained the most in three weeks versus the US dollar as crude oil held above $104 per barrel. But the loonie’s rally will probably be capped by political uncertainty, after Prime Minister Stephen Harper’s government was toppled by opposition lawmakers.

The commodity rally and a return to “risk” trades has helped push the Australian dollar to the highest level versus the US dollar since 1983. The Aussie dollar traded above $1.03 for the first time since it began trading freely, surpassing the previous record which it hit on Thursday of last week. The combination of rising commodity prices, and positive interest rate differentials has encouraged investors to flock back into the Aussie dollar.

Both the gold price and silver price are off their highs of last week, but are still trading at fairly strong levels. The precious metals declined on Friday on signs that the US economy is improving, decreasing the need to hold them as a hedge. Bullard’s talk of ending QE2 early eased inflationary concerns, pushing the metals lower. NATO success against Libyan military forces have also helped ease the “need” for the relative safety of the precious metals. Global events over the past few months confirm our belief that all investors should hold a diversified portfolio including metals and currencies. Diversification is an investor’s best protection against the unknown!

Recap: St. Louis Fed Head suggested the FOMC should look for an early exit to QE2, which pushed the dollar higher. Portugal had a ratings decrease, but the President is confident that he will be able to get his government to accept austerity measures. The euro will be tested by Italy’s bond auction this week, but is looking like it will hold up above $1.40. The pound sold off as UK business confidence is at the lowest point in two years. Commodity currencies continued to rally as “risk” trades were put back on, and gold and silver sold off their highs, but continue to protect investors.

Chris Gaffney
for The Daily Reckoning

The Daily Reckoning