Shift in tone from Fed officials keeps dollar volatile

It has been a fairly muted start to the day for risky assets. Stocks are lower along with the dollar, which remains lower on a broad-based basis. But the market remains on the defensive after a notable shift in tone from members of the US’s Federal Reserve in recent days, which is weighing on stocks and keeping the dollar volatile.

Fed members are prepping the market for the end of quantitative easing and this continued this morning with St Louis Fed President James Bullard who said that growth prospects had improved recently and that “the natural debate is how and when the exit should begin”. Bullard who is typically on the dovish end of the Fed, added that turmoil in the Middle East, the nuclear crisis in Japan, the US fiscal crisis and possible government shut down along with Europe’s sovereign debt crisis all had the potential to de-rail the Fed’s exit strategy. But he said that right now the chances were that all four events would be resolved and that the Fed “may not be willing or able to wait until all global uncertainties are resolved to begin normalising policy.”

This caused some covering of dollar shorts and EURUSD is down about 20 points. Going forward, the dollar and Treasury yields will be sensitive to expectations of an exit from QE2. We haven’t heard from Bernanke or Dudley, arguably the most important Fed members, and it will be interesting to hear what they have to say and if they share the same view as their fellow committee members. Bernanke next speaks on 5 April at a conference hosted by the Atlanta Fed. This will be a major market event.

In the UK the final reading of Q4 2010 GDP was slightly less dismal than the second reading suggested rising to -0.5% from -0.6% previously. The breakdown in the data was interesting. Investment, household spending and trade all weighed on growth. Imports outpaced exports for the second straight quarter, which suggests that the government’s so-called export led recovery is a bit of a fantasy and did not benefit from the 2-year depreciation of sterling. The contraction in household spending is only expected to get worse, and since this makes up the bulk of UK growth it leaves us fairly downbeat on the prospects for the UK economy going forward.

The pound has been weak since the minutes of the MPC meeting last week and this data had little effect on asset markets. Ahead today Martin Weale speaks at 1600 BST, he has twice voted for a rate hike so it will be interesting to hear what he says regarding the dip in growth and his commitment to tightening monetary policy.

The dollar has strengthened today on the back of dollar weakness, but also because we are now on the count-down to the next ECB meeting on 7 April when the central bank is expected to raise interest rates. This is likely to keep the euro well supported, even in the face of sovereign fears. How long the euro will maintain its yield differential is unknown and depends on the Fed maintaining its “policy normalisation” stance. But until we hear more from ECB President Trichet at next week’s meeting we are wary of calling the top in the single currency just yet.

French consumer spending for February was higher than expected, rising 0.9% vs. expectations of a 0.5% gain; this helped set the stronger tone to the euro from the start of the European session. Peripheral bond yields have moderated slightly but remain at dangerously high levels in Portugal’s case. For now the spotlight has shifted to rates, but the sovereign crisis continues to dominate the credit markets, although we think there is limited scope for FX markets to be affected unless Spain gets into to some trouble.

Elsewhere, the Aussie dollar continues to follow stocks closely and has come off on the back of lower equities. AUDUSD is no longer being driven by yield differentials (Aussie yields are now less supportive of currency strength); instead we don’t expect to see AUDUSD take another stab at record highs until stocks move higher.

Gold is lower, while oil is mixed. Overall this is a sluggish day. Ahead today, US consumer confidence will be the key data out of the US.

Source: Forex.com

29.03.2011