USD underperforms

The Fed expanded its asset purchases by buying $45 billion in longer dated Treasuries following the end of Operation Twist, with total purchases at USD 85 billion per month. The Fed went a step further by changing the guidance, now anticipating that policy will be maintained at an “exceptionally low range for the Fed Funds rate” as long as the unemployment rate remains above 6 ½ % and inflation no more than ½ % above the Fed 2% goal.

Equity market reaction was limited, with any positive boost dampened by the recognition that the Fed will not be able to offset the blow to the economy from the fiscal cliff. On this front, progress has been limited as the likelihood of a deal by the end of the year is diminishing by the day.

In Europe sentiment is somewhat better as hopes that the EU Council meeting today will yield an agreement on banking union and supervision. Final approval for the delayed Greek loan tranche is likely to be delivered following the completion of Greece’s debt buyback. The better news in Europe will be reflected in a decent reception to the Spanish and Italian bond offerings today.

The USD did not take too kindly to the latest efforts by the Fed to boost the economy although there are clearly diminishing returns as far as FX markets are concerned with regard to Fed QE. Nonetheless, the USD is coming under growing pressure into year end.

Next year assuming that the fiscal cliff in the US is resolved, with a limited fiscal drag on the economy, a relatively positive growth trajectory for the US alongside an expected increase in US bond yields will mean that the USD will still enjoy gains against currencies with weaker growth paths namely the EUR and JPY.

My forecasts for the USD index based on forecasts for its constituents show a gradual strengthening over the course of the next couple of years (82.4 and 85.7 by end-2013 and -2014, respectively) largely due to the USD’s expected appreciation versus EUR and JPY. In reality, this is misleading as improving risk appetite and continued capital inflows to EM and commodity currencies will mean that the USD will underperform.


Reality Check

Markets face a reality check going into this week. The euphoria emanating from recent Fed, ECB and BoJ actions is fading quickly. The reality of weak growth and underlying structural tensions is coming back to haunt markets, suggesting much more limited upside for risk assets over coming weeks.

While there are some positive indications that the growth outlook may not have much further to deteriorate, such as the bounce in the Baltic Dry Index, scepticism about the ability of central banks to reflate economies is growing. In this respect, its worth highlighting that the rally in gold prices failed to extent much further last week although in part this may be due to an options expiry tomorrow.

Renewed tensions are creeping back into the market psyche, especially with regard to Europe. Procrastination from Spain about a formal bailout threatens to weigh on markets in the days ahead as some officials suggest that the EUR 100 billion received for Spanish banks will be sufficient for the country to avoid needing further aid. Bank stress test results, a Moody’s review on Spanish ratings and the country’s 2013 budget will all be scrutinised over coming days.

Meanwhile, disagreement between Germany and France over the timing of introducing banking union and supervision is accentuating tensions in the region. Greece remains in the limelight too, as the government continued to find further budget cuts in order to receive the next tranche of loans. The only good news appeared to come from a German press report that the ESM permanent bailout fund’s firepower will be leveraged up to EUR 2 trillion.

The EUR has lost momentum following its initial surge higher and looks constrained on any move above 1.3000. While EUR short positions have continued to be pared back according to IMM data the scope for short covering is becoming more limited. Developments in Spain and Greece will provide further guidance for the currency, but any upside in EUR/USD will be limited to resistance around 1.3180. It seems more likely that having failed to sustain gains, the EUR will continue to drift lower.

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