The buck is poised to claw back losses

Kathleen Brooks
YESTERDAY was like a trip down memory lane with traders across the City gripped by the conclusion of the Federal Reserve’s latest policy meeting. The big news was that the Fed will not engage in more quantitative easing (QE) and instead reinvest the proceeds of securities it already holds on its gigantic $2.3 trillion balance sheet.

So now that investors have resumed watching the Fed like a hawk, what does this mean for the greenback? In the near-term the dollar could actually strengthen, says Glenn Uniacke, senior dealer at Moneycorp, the currency specialist: “Market expectations for a further round of quantitive easing have not come to light after this meeting. This shows that expectations were over-cooked, which could help the dollar claw back some losses.”

Uniacke says that euro-dollar could re-trace back to $1.28; currently one euro gets you $1.32. Michael Hewson from CMC Markets says that the pound’s failure to break above the psychologically important level of $1.60, could see sterling fall to $1.5520-50 in the coming days, especially since the Fed did not opt to increase policy support for the economy.

However, the longer-term picture is less promising for the greenback. Compared to the European Central Bank and the Bank of England, which have pledged to cut the size of their balance sheets after providing huge amounts of stimulus during the peak of the financial crisis, the Fed looks a long way off from following suit. “Reinvesting the proceeds of securities it already holds could amount to $200bn by the end of the year, no small fry,” says Uniacke.

At this stage the Fed is in wait-and-see mode. But if economic data continues to disappoint, then the Fed would be ready to provide more policy support. As analysts at Societe Generale note, an addiction to quantitative easing will undermine the G3 currencies: “Our core currency view is that G3 FX is a losers’ competition. We remain biased to sell the yen, euro and dollar against alternatives that aren’t burdened by massive deficits and zero rates.” An even larger deficit in the US would only make the dollar look uglier than it already does.

But the dollar is not the only currency at risk. Europe’s fortunes are intertwined with those of the US. A rebound in US business investment, as you can see in the chart, has coincided with a large increase in capital goods imports. As Capital Economics notes, this has helped big capital equipment exporters such as Germany. But if the US slows, imports will dry up, having a knock-on affect on growth rates for these countries and therefore, the euro.

At the time of writing, the dollar had conceded more territory against the euro. But it may claw back some gains as the market “prices out” the possibility of any near-term QE. For now, short-term dollar strength could reap profits. The longer-term outlook all depends on the Fed, so keep watching.