Same Pendulum Different Name

Since late January, we maintained the Fed would not alter its monthly shopping list of $85bn in treasuries and agency securities this year. But no matter how certain we might be of this assessment, it is the path towards this conclusion, which matters most and yet remains cloudy. All roads may lead to “Rome”, but the exact path shall remain volatile (subject to data, reporters’ articles and Fed speeches/interviews).

Considering Fed Chairman Bernanke’s accommodation of the financial markets since QE1 in March 2009, the Chairman’s readiness to stimulate has continuously been the path of least resistance and of the most support by financial markets.  Tapering the current round of asset purchases is highly unlikely, despite any rhetorical preparations and testing for the markets.

Same Pendulum, Different Name

So far this year, we’ve had 4 Fed meetings, 4 US jobs reports and 2 Congressional testimonies by Fed Chairman Bernanke. Currency markets interpreted each event with one of the following ways: Fed will reduce its $85bn in monthly asset purchases (tapering); maintain the purchases intact (taper off); or the possibility of increasing the purchases (raising QE).

None of this is much different from this time one year ago when US data reports were interpreted by either of the two interpretations; QE3, or sticking with operation twist (selling short term bonds and buying long term bonds).  Go back 1 year further (2011) and the general interpretation was again either QE2 or no more QE2.

In each case, the market reaction function was and remains generally the same: a binary set of interpretations, implying more Fed stimulus, or maintaining the status quo. The latter would mean a stronger US dollar, falling European and commodity currencies and weak global equity indices. More Fed stimulus would imply the opposite.  This used to be called risk-on, risk-off, now it is referred to as taper-on, taper-off.

The “stimulus” side of the equation was further bolstered by the ECB’s September announcement to be willing to show its own version of QE (Outright Monetary Transactions) in order to stabilise sovereign bond yields and give politicians time to implement. It worked. Markets hit new highs, yields hit 3-year lows, the euro stabilised, shrugging an election impasse in Italy and penalizing depositors in Cyprus. The ECB has addressed the issue of “market stress”, now it faces the “macro stress”. Slashing ECB interest rates to negative will return to the agenda in autumn. 

How to Trade it?                    

When all said and done, we expect the Fed to maintain its $85bn monthly purchases unchanged into mid Q1 2014, and the ECB to slash interest rates to negative levels by year-end. This may imply a neutral-to-strong US dollar, but with a higher confidence level play in selling the yen against both USD and EUR.

The yen’s occasional gains during rare risk aversion episodes remain an opportunity to sell at higher levels, while the reactionary pullbacks in the US dollar from “taper off” signals become a greater opportunity to buy the US currency on the bolstering premise that another 9-10-year bear market in the greenback has been played out.