Charts: How End of QE Could Impact EURUSD and USDJPY

By the end of this month, the Federal Reserve will have completed its asset purchase program, bringing its second round of Quantitative Easing to an end. As QE2 draws to a close, it is worthwhile to consider how the dollar could react. When the first round of Quantitative Easing came to an end, we saw a massive dollar rally (see EUR/USD chart below). USD/JPY did not participate in the rally because of lingering concerns about the need for more stimulus (second chart). The dollar index on the other hand rallied as much as 10 percent as the greenback strengthened against high yielding currencies (third chart) – this suggests that once QE2 ends, we could see a more significant dollar rally.

How EURUSD Reacts to Non-Farm Payrolls

Trading the Fed meeting is always difficult because in addition to a decision on rates, the tone of the FOMC statement also affects how the dollar trades. Rather than immediately jumping into the market after the announcement, I have found that in 11 out of the last 14 times that the Federal Reserve has met, the move in the EUR/USD during the U.S. trading session continued into the Asian and London sessions. More specifically, the dollar’s move between 2:15pm and 4pm NY time tends to follow through from 4pm to 12pm EST (noon) the following day. The table below illustrates the reaction in the EUR/USD from 2:15 to 4pm on FOMC day and from 4pm to 12pm EST the next day. For forex traders that may not know how to interpret and trade FOMC, this suggests that it may be better to wait and see how the market reacts before jumping in because continuation is very likely.

What are the Fed’s options?

1. A dovish statement that reinforces Bernanke’s recent concerns > initially dollar bullish

2. Dovish statement with talk of more QE (ie. Balance Sheet expansion), but not actually doing it > slightly dollar bullish

3. Dovish statement, reinvest MBS proceeds > dollar bearish

4. Dovish statement, expands balance sheet (ie. additional QE) > very dollar bearish

British Pound Soars on King’s Comments, 1.50 is Resistance

Over the past 2 weeks, the British pound has soared more than 8 percent against the U.S. dollar. Like many countries around the world, the U.K. has succumbed to higher gas prices but unlike some other countries, the weakness of the British pound has exacerbated the rise in inflation. Hotter consumer prices helped to fuel today’s gains in the British pound, but it was comments from Bank of England Governor King that took the GBP/USD above 1.47. Quantitative Easing has been kept a lid on gains in the pound, causing it to under perform currencies such as the euro. The CPI numbers are significant however because annualized CPI is now BACK ABOVE the BoE’s 3 percent target.

However this morning, BoE Governor King talked UP the pound, which is a dramatic departure from his previous comments. He said that there is “no reason why the sterling should go any lower” and that the sterling’s fall was not engineered. He also said that the central bank originally aimed for GBP75bn of Asset Purchase Facility over 3 months but “might need to do less if it works.” These positive comments are probably a reaction to the recovery in the equity markets and the recent drop in bond yields.

The 1.4650 level in the GBP/USD is fairly significant (100-day SMA). If the currency pair manages to hold above that level, the next area of resistance is 1.50.

source: eSignal

source: eSignal

EUR/USD Could Extend to 1.40

The EUR/USD is on a tear, having rallied more than 600 pips or 5 percent over the past 24 hours. The significance of Fed’s actions continue to resonate over the currency markets and even though we have already seen parabolic moves in the pair, I think it will head higher.

Why?

On December 16th, when the Fed first brought up the prospect of buying U.S. Treasuries at their FOMC meeting, the EUR/USD rose from a low of 1.3629 to a high of 1.4719, an 8 percent move. Now that the Fed is actually following through with buying longer term Treasuries, the impact on the EUR/USD should be the same if not greater.

We have seen a similar reaction in the British pound. After officially announcing Quantitative Easing, the GBP/USD fell 650 pips, a move of only 4.5 percent. However the price action of the GBP/USD has been diluted by the weakness of the greenback and so a more accurate reflection of the market’s appetite for British pounds post Quantitative Easing can be found in EUR/GBP which has rallied 8 percent since the March 5th Bank of England meeting.

Source: eSignal

Source: eSignal

Therefore an 8 percent move in the EUR/USD post FOMC would take the currency pair to at least 1.40 from Wednesday’s low, which is my target over the next few trading days.

Source: eSignal

Source: eSignal

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How Does the Fed “Print Money?”

With the Fed’s announcement today, many people may be wondering “How does the Fed print money?” Here is a snippet from my Daily Piece on Currencies.

Most of the time when we say that a central bank “prints money” that does not mean that they actually fire up the electronic version of a printing press. They can and this is the way Bernanke described it in 2002 when he said that “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

However more often printing money means that the Federal Reserve will hold an auction to buy assets like bonds or mortgage backed securities from banks. Then they issue a credit to the bank’s account, creating new money and the hope is that the bank will use the money to lend to businesses and consumers.

Unfortunately by increasing the supply of dollars, each dollar is worth less. The U.S. government also increases its debt burden, raising concerns for foreign investors. This is compounded by the fact that the Fed’s purchases of Treasuries will drive down bond yields, reducing the attractive of dollar denominated investments.

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