Tail Risk will End up Chasing its Tail

<p>Bernanke’s readiness to do more (today or next month) and Draghi’s bond-purchase plan is not only a game-changer, but a sharp blow to “tail risk”, […]</p>

Bernanke’s readiness to do more (today or next month) and Draghi’s bond-purchase plan is not only a game-changer, but a sharp blow to “tail risk”, and is an added boost to supporting market confidence.

There is as much as 60% chance of QE3 being announced at today’s FOMC decision (12.30pm ET, 5.30pm BST).  Bernanke’s conference follows at 2.15pm ET (7.15pm BST).

Although we do not expect QE3 to be started today (US data and markets do not yet merit immediate stimulus), one argument favouring QE3 today is that Bernanke will use the scheduled press conference to explain the new program, rather than waiting for the October meeting, which has no schedule press conference, and therefore no opportunity to explain any new announcement apart from the statement.

Any QE3 announced today is expected to take the form of purchasing US Treasuries and Agency Mortgage Backed Securities (MBS). It is not clear whether the Fed would specify any amount, and instead may announce an-open ended program.

Watch the third paragraph of the FOMC statement (known as the forward guidance), focusing on the guidance phrase in the final sentence, is likely to be changed from the current sentence: “… warrant exceptionally low levels for the federal funds rate at least through late 2014“, to: “… warrant exceptionally low rates at least 2015.  Such an extension would likely serve as an offset for any disappointment from no QE3 today and will underline the readiness for the Fed to do more if conditions required them.

And so instead of announcing the start of QE3 this week, Bernanke will likely reiterate the Fed’s readiness to undertake more measures QE3 in the event of future deterioration in conditions. The lack of any QE3 on Thursday may lead to temporary pullback in risk currencies (especially AUD, GBP, CAD as well as metals) before a firm rebound (as soon as in late Friday Asia trade) based on the anticipation that QE3 is simply an eventuality and/or optimism that a one-year extension of exceptionally low US rates will keep easy money well injected into an addicted system.

The third blow to the US dollar (apart from Draghi’s Plan & QE3 expectations) is re-emerging warning on Moody’s US credit outlook. Although the warning was based on lack of progress on the US deficit negotiations, it is a rude awakening of the US debt mountain, and the simple fact that the world’s biggest economy has yet to conduct any austerity policies.

Market metrics suggest EUR/USD at 1.32 (key support at 1.2650), GBP/USD at 1.63 (support 1.6020), S&P500 above 1440 (support at 1395) and gold above 1820 (support at 1660) remain the high profile market consequences of the above central bank assessment within the next three to four weeks.

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