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Thu 14 Oct 2010 04:29 PM

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QE2 no one-way bet against the dollar

All GCC currencies are tied, wholly or in part, to the greenback. So what is going to happen? Is another round of quantitative easing the right solution?

QE2 no one-way bet against the dollar
QE2 no one-way bet against the dollar

Selling the dollar has been a one-way trade of late as the Federal Reserve looks poised to pump more cash into the economy as early as next month, but the bulk of the impact of extra easing may now be priced in.

The dollar lost 8.5 percent against a basket of six major rivals last quarter, the most in eight years, on fears money-printing by the central bank will debase the currency. Speculators pushed bets against the greenback to $22bn in the week ended September 28, the highest since at least mid-2008.

The dollar’s downtrend comes at a time when many other countries are trying to weaken their currencies or at least slow their appreciation. That has fueled fears a global currency war could derail economic recovery.

The fall in the dollar has been so dramatic that some now believe the market may be getting ahead of itself, setting up investors for disappointment should policymakers fail to deliver.

“The risk is that once it becomes reality, it will be a smaller program than the market thought and that will be a catalyst for a dollar bounce,” said Richard Franulovich, senior currency strategist at Westpac in New York.

“There’s too much division (within the Fed). There’s no way you can get a big program in place, like $1 trillion, with that much division,” he added.

While some Fed officials such as New York Fed president William Dudley said more action is warranted, Dallas Fed Bank chief Richard Fisher and others believe a further relaxation of monetary policy may do more harm than good. The Fed has already pumped $1.7 trillion into the economy through purchases of Treasuries and mortgage-related debt.

If the Fed does decide to purchase more bonds, many economists say it will likely opt for a gradual, open-ended approach and a smaller amount than the first round of quantitative easing (QE) implemented in March, 2009. QE is seen as negative for the dollar because it tends to lead to higher inflation expectations and lower real rates.

UBS does not expect any Fed action, though it said there’s risk around that view. The bank targets euro/dollar at $1.25 in three months.

Fed officials and investors will be in data-watching mode ahead of the central bank’s next meeting on November 2-3, with the key September jobs report due out this Friday and the first estimate of third-quarter growth on October 29. Surprisingly strong data could shake expectations for the Fed, forcing a squeeze of dollar shorts.

While the dollar is set to remain on the back foot until the Fed meeting, analysts believe the impact of additional quantitative easing would be more moderate than the first round.

The US inflation rate has drifted higher in recent days, partly helped by Fed easing expectations, and is now well above levels seen before the first round of QE. Ten-year inflation expectations, as implied by inflation-linked government bonds TIPS, last traded at 1.97 percent, according to Reuters data. That was up from about 1.5 percent in late August.

Real rates, based on TIPS, are at all-time lows near 0.4 percent, raising questions about how much more the Fed can push them down.

“There is less potential for the Fed to move these parameters and affect the dollar this time around,” Jens Nordvig, head of G10 foreign-exchange strategy at Nomura in New York. “We think the US dollar weakening move is likely to be entering its final phase.”

The worst scenario for the dollar, said Ron Leven, senior currency strategist at Morgan Stanley in New York, is if the Fed move sparks a simultaneous rally in stocks and bonds.

The two markets tend to move in opposite directions, but that correlation broke down during the first round of QE and weakened again in recent months on a view that more cheap money would lead to higher corporate profits and demand for bonds. This would boost risk appetite and hurt bond yields, creating a double negative for the US currency.

Any Fed easing could also see other major central banks follow suit, limiting the downside for the dollar.

The Bank of Japan surprised the market on Tuesday by pledging to pump more funds into the economy. There are calls within the Bank of England for further easing.

The European Central Bank bought the largest amount of bonds since July last week during worries about peripheral finances, despite speculation it would remove policy stimulus sooner rather than later.

“Simply announcing QE does not really mean it’s going to be a never-ending sell for the US dollar,” said Ashraf Laidi, chief market strategist at CMC Markets in London. “The gate has been opened for further easing by major central banks. The very dynamics that lead the Fed to pursue QE-2 could very well push other central banks into easing.”

ALAVI 9 years ago

This is bad news. U.A.E. currency is based on US$ .If U.A.E. does not take immediate action and have DIRHAM value to what it should be (at least 1 AED=1USD) , the side effect will be high and negative.