Is this a turning point for the dollar?

Ben Bernanke’s second ever press conference seemed to rule out almost entirely the prospect of further policy stimulus even as the US economy is going through a soft patch and the unemployment rate has been rising.

The Fed believes that the factors weighing on growth are temporary including higher commodity prices constraining consumption and disruption from the Japanese earthquake to the supply chain that has hit industrial production. It also believes the pace of recovery will pick up later this year.

However, it did sound a note of warning about inflation saying that it had noted the pace of price increases recently and it would continue to “pay close attention to the evolution of inflation and inflation expectations.” This was considered more “hawkish” than some had expected, however, like the Bank of England, the Fed thinks that inflation will eventually moderate when commodity prices fall.

Although QE2 is coming to an end this month and there was no hint that QE3 would be forthcoming, the Fed also explicitly stated that the current economic conditions would require an extremely accommodative level of interest rates for some time to come.

Conspicuous by its absence, however, was reference to the size of the Fed’s balance sheet. At its last meeting the Fed discussed various ways to normalise monetary policy and the favoured option appeared to be to stop reinvesting the proceeds at maturity of agency securities first and then Treasuries. Although the Fed said that it would continue to reinvest the proceeds this month it stated that it will “regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.” So if economic conditions do pick up later this year then loose monetary policy cannot be guaranteed, since shrinking the size of its balance sheet is another form of tightening.

But does this mark a turning in the dollar? It has sustained gains post the Bernanke press conference, which has weighed on the dollar crosses. Currently EURUSD is below 1.4300 and GBPUSD is below 1.6000.

However, while we think a floor has been put in for the dollar for now there are many reasons we are sceptical that the buck will rally quite yet. Firstly, the Fed could change its mind if the economic situation deteriorates, so we need to see how the data pans out over the next few months. Secondly, the US still faces a political wrangle to get Congress to agree to raise the debt ceiling so the US can avoid bankruptcy later this year. Although we think the debt ceiling will be extended, the US’s massive $14 trillion debt load means that we are unconvinced at the extent the dollar can rally. With debts that big the US needs a weak currency to firstly, boost exports and secondly, to create a little bit of inflation and thus bring down the size of the debt in real terms…

But sentiment towards the euro is falling, which is weighing on stocks and other risky assets. Part of the reason for the weakness in the single currency is the rebound in the dollar, but it may also be due to deterioration in investor sentiment before the crucial Parliamentary vote on Tuesday in Athens where the latest austerity measures have to be passed to ensure the release of the latest tranche of bailout funds.

Reporters have surfaced that talks between EU officials and Greek, French and German banks on the subject of debt rollovers have started to take place. German officials have insisted they will follow the ECB’s lead and only rollover debt on a voluntary basis, so the great charm offensive is now on.

There was some poor economic news that is also going to limit euro upside today. The final PMI’s for the service and manufacturing sectors were revised lower for June. This suggests that Europe is following the US into a summer economic malaise.

The pound is under pressure and is below key support at 1.6000. The weakness has stemmed from yesterday’s minutes of the last BOE meeting, which suggested that the Bank would think about a further round of QE if the economy does not pick up. BOE member Adam Posen, who has consistently voted to increase the size of QE, will speak later this afternoon, which is worth looking out for to see the depth of interest in the Committee to provide further stimulus to the UK’s fledgling recovery.

This has hit interest rate expectations and 2-year Gilt yields have fallen to lows last reached in November, which is hobbling the outlook for the pound.

Ahead today jobless claims in the US and new home sales data will be the focus along with BOE dove Adam Posen.

Source: Forex.com

23.06.2011