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In the end Wednesday, the markets got just about what was expected from the FOMC and Fed boss Ben Bernanke. While a certain notable French bank who shall remain nameless (OK, it was Société Générale) came out with 70% odds of a $600bln round of new quantitative easing (aka QE3), that was an outlier view. Most folks in the fixed income and forex markets (we don’t pay much attention to the stock guys :) ) were looking for a continuation of the Operation Twist program in which the Fed sells short-term treasuries it owns and buys longer-term ones.

These expectations are why in the end the various global markets basically just continued on the course they had already begun earlier in the day, albeit with a little volatility after the FOMC statement and into Bernanke’s press conference. Following the extension of Twist, the Fed chief’s comments about standing ready to do whatever may become necessary were predictable. He’s been saying that for some time now. Why not? It’s true. It’s always true. The Fed will do what it thinks it needs to do when it thinks it needs to do it. Folks seem to read QE3 expectations into that every time he says it, though.

To that end, it occurred to me yesterday that the folks who keep calling for QE at the next FOMC meeting are kind of like the folks who set dates for the end of the world, then when it doesn’t happen they revise to a future date.

The thing that had me sure there was no QE3 coming this week was a comment Bernanke made a little while ago that he was seeing no signs of deflationary risks at present. Deflation risk was a big factor in the justification for QE in prior rounds, so if he’s not seeing that risk now, the odds of QE3 drop despite economic developments. Now, the Fed forecasts released yesterday did feature lower inflation expectations, but nothing leaning toward deflation. That will be something to watch morning forward.

At this stage, the bigger issue at hand is going to be the value of the signals coming from the Treasury market. As I wrote a couple weeks ago, the Fed already owns a large portion of outstanding long-term Treasury paper. The extension of Twist is only going to make that share grow. The bond market guys I work with say basically the Fed will be buying all of the long-dated paper the Treasury issues for the rest of the year. This is going to further shrink the “float” of long-dated securities, which could make the likes of US 10yr yields even more volatile because it will take increasingly smaller volume to move them around.

Considering how correlated USD/JPY tends to be to those rates, the higher volatility in yields could make for some interesting action in that exchange rate. Notice in the chart below how much time the correlation between the two markets is positive and how even when it turns negative it is just briefly and only marginally so. If the 10yr yield becomes less valuable as an indicator due to the Fed’s dominant holdings, we could see the relationship between it and USD/JPY breakdown.

Also, things could get interesting on the short end of the yield curve as well.

The Fed normally holds a lot of short-dated Treasury paper which it uses in open market operations to keep short-term yields in line with policy. The Twist operation has already seen a lot of that paper sold as the Fed has bought long-dated securities. The expectation in the bond market is that the Twist extension will result in the Fed not having any shorter-term paper left. That could create some interesting dynamics at the front end of the yield curve. Considering how important overnight interest rates are to currency exchanges rates, there is the prospect of some periods of unusual activity in the months ahead. As a result, it will be worth keeping track of what the Fed is doing.

This is one of those times when understanding structural elements of the markets can be important.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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Even if one is a short-term trader, it is worth taking a look at the longer-term chart from time to time to see how things are developing in the higher time frames. My daily work has me usually focusing on daily and intraday charts, but now and again I’ll flip over to the weekly chart to gain that broader perspective. The thing I noticed today was an interesting development on the weekly USD Index chart.

As you can see below, the Bollinger Bands in that time frame have been getting progressively narrower since about the first part of the year. They are now very narrow. In fact, on a relative basis (as shown by the purple Band Width Indicator sub-plot) they are as narrow now as they got late in Q3 last year. Notice what happened then.

Since the USD Index is heavily weighted to the euro, we basically see the same narrow-Band situation for EUR/USD as we do for the index – just with the chart inverted.  We see similar tight Bollinger set-ups in GBP/USD and USD/CHF, which isn’t too much of a surprise given how closely related those currencies are from a fundamental (and central bank) perspective these days.

The interesting thing, however, is that once you get outside the European currencies the story is different – considerably so in some cases. The narrow-Band situation actually produced a major breakout in USD/JPY earlier this year. Now we’re seeing the market consolidate after its powerful rally.

In the case of AUD/USD, we’ve got a market basically working through a sizeable range that’s been working since the highs were put in last year. We’re now seeing the market having turned down from its latest swing up, looking quite like it’s headed back for the bottom of the zone.

If we flip AUD/USD over we get a pretty close approximation of how USD/CAD has traded. There difference, though, is in the recent action. Where the Aussie has been selling off, the Loonie has been holding steady over the last couple of months.

So what does this all seem to say?

My interpretation would be this. The relatively better performance of the CAD vs. the AUD is indicative of at least the perception of the situations with the US and China respectively. These currencies are seen as closely linked via trade to their large neighbors, so as the US data has gotten better, the CAD has been supported, and as the China data has disappointed, the AUD has weakened.

Japan is largely its own situation. There is certainly some impact from China there, but mainly the yen trades as a function of two things. One is the stagnant economy in Japan, which is showing little sign of doing anything any time soon. The other is US interest rates. The correlation between USD/JPY and the US 10yr yields is quite strong as higher US rates make the yen more attractive as a carry trade funding currency than the dollar, plus more attractive for investment returns.

Then there’s Europe. To my mind, the ranging we’ve seen in the major pairs there is reflective of the markets getting a handle on where everything stands. We’re basically waiting on the next meaningful development. My guess at this point is that will have more to do with the US than it will Europe. I say that because the market seems to see the Eurozone issues as pretty clear with little change expected out of the ECB for a while. If anything the leaning is toward further loosening of policy by that central bank.

In the case of the US, though, the situation is on more of a knife’s edge. As we saw from the reaction to the FOMC meeting minutes Tuesday afternoon, there have been a number of market participants looking for another round of QE3 from the Fed (including the likes of Goldman Sachs). At the same time, though, we have others who see the US on a good sustained growth path. The USD is likely waiting to see which side is going to win that argument. How the USD Index moves out of its current consolidation will be indicative of which way that fight ends up going.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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The market is talking about QE3 again after last week’s shock miss on US payrolls. Those who think it’s coming are pointing to the minutes of the last FOMC meeting as evidence in support of their case as they noted that “some” Fed officials said some more easing might be need in the unemployment rate doesn’t start moving down and inflation returns to low levels. That latter part is the important one, as I think most folks right now will have a hard time suggesting we’re in a low inflation environment and “a number” of Fed officials see the inflation risks as biased to the upside.

In other words, if you’re expecting QE3 you may not want to hold your breath. One of my colleagues here actually thinks it would take the stock market falling about 20% to spur Bernanke & Co. into action. That would put the S&P 500 on the way down to 1000. I wrote a post recently on stock traders positioning themselves bullishly because they expected the Fed to protect their downside with more QE. Not sure how they’d be feeling 20% down. On the plus side, if that were to happen, it would likely mean the dollar had strengthened a fair bit, giving the Fed some market cover to do further easing.

But guess what? The Fed is actually tightening right now.

Follow me here.

The Fed has indicated its intent to roll over maturing securities to maintain a steady balance sheet. That means when they receive the principle back on a bond or note they are holding, they turn around in use the proceeds to buy Treasury securities. That’s why you’ll continue to see the Fed doing their reverse auctions periodically. What that will serve to do is slowly shift the composition of the holdings away from mortgage and agency paper to Treasury debt.

But here’s the rub. The Fed hasn’t said anything about reinvesting the income they get from those holdings – the periodic interest (coupon) payments. The income the Fed makes from those interest payments is largely getting passed along to the Treasury as part of its annual remittance of excess profits. That’s been tens of billions of dollars in recent years because of the size of the Fed’s balance sheet.

The money supply math of the Fed is that when it buys securities from the market it prints money, thus increasing the money supply (at the monetary base level). Flipping that around, when the fed sells securities to the market (as it’s expected to do when it finally gets around to unwinding QE) it drains money from the market. When the Fed is repaid its principal the money supply is reduced, so it goes out and buys more to keep the money supply level.

Interest payments to the Fed are just like principle repayments in terms of reducing money supply. It’s money from the market that goes to the Fed and is effectively destroyed. These interest payments are not being reinvested, so the money supply is slowly drained from the system.

Now, by comparison, these interest payments are a small fraction of the total money supply (only a few % given interest rates), so it’s not like we’d expect to see a major drop in M2 money supply as a result. Also, as the mortgage and agency holdings are slowly converted to Treasury holdings through the mature-and-reinvest process, the impact of the drain will decline. This is because the mortgage and agency interest is coming from the private sector while interest on Treasury debt is government money which isn’t part of the private sector money supply, and is largely returned to the government anyway.

Obviously, the small relative size of the interest income makes this money supply drain little more than a trickle (though tens of billions does sound like a lot). My point isn’t that the Fed has engaged in a noteworthy stealth tightening since ending the QE2 purchases. It’s more than we need to make sure we understand the mechanism of things to know what’s really going on.



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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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Looks like the Fed is considering untested means of stimulating growth…it’ll be interesting to see how this one plays out.  Read more about Bernanke’s new plans here.

Bernanke lays out easing options

WASHINGTON (MarketWatch) – While the Federal Reserve believes that the temporary shocks holding down economic activity will pass, the central bank is examining several untested means to stimulate growth if conditions deteriorate, including another round of asset purchases, dubbed QE3, Fed chairman Ben Bernanke said Wednesday in remarks prepared for the House Financial Services Committee. Bernanke discussed three approaches to further easing in his prepared remarks. One option, Bernanke said, would be for the Fed to provide more “explicit guidance” to the pledge that rates will stay low for “an extended period.” Another approach would be another round of asset purchases, or quantitative easing, or for the Fed to “increase the average maturity of our holdings.” Finally, the Fed could also reduce the quarter percentage point rate of interest that it pays to banks on their reserves, “thereby putting downward pressure on short-term rates more generally.” Bernanke was clear to stress that easing was not the only option under consideration and that the next Fed move could well be to tighten. At the moment, Fed officials see a recovery that “will likely remain moderate,” Bernanke said, with the unemployment rate falling “only gradually.” Inflation is expected to subside in coming months, he said.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

After another week of big news in the world currency markets, check out the top stories that caught our attention:

This week, much of the news in the foreign exchange world focused on a continuously troubled Greek economy. As European stocks have fallen and the euro faces pressure, Greece plans to sell off billions of dollars in state assets to raise funds in order to meet the demands of international lenders. Also, as gold pricing recently reached record highs, many Greek citizens have used their savings to buy gold in preparation for a possible sovereign default. In other news, Federal Reserve Board Chairman Ben Bernanke has downplayed the chances of QE3, citing improvements in the U.S. economy from the same period last year. Meanwhile, the latest annual World Wealth Report shows that there are now more rich people in the world than ever before, as the number of people with more than $1 million of investable assets has jumped 8.3% in the past year. And Bitcoin, the virtual currency, still has the Forex world buzzing. A major Bitcoin was hacked, causing its value to significantly decrease and leading many to wonder whether this controversial currency will last.

• Greece prepares to sell off state assets to get loans, CNN, June 20, 2011
• Everything Is Going Wrong At The Same Time For Controversial Virtual Currency Bitcoin, Business Insider, June 20, 2011
• Gold Rises to New Record in British Pounds, Seeking Alpha, June 21, 2011
• Ben Bernanke Plays Down QE3 – Dollar Stronger, Forex Crunch, June 22, 2011
• Greeks Turn Savings to Gold And Perth Mint Silver Coin Sales Surge To Record On Safe Haven Demand, Zero Hedge, June 22, 2011
• Where the rich are keeping their money, MarketWatch, June 24, 2011

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.