Twists and turns for the Fed

The FOMC meeting later today will dominate the markets today and could even distract attention away from Greece and the Eurozone. Below are the main market themes so far today:

• The markets have already priced in the prospect of more policy support by the Fed, hence why 2-year US Treasury yields have fallen from more than 40 basis points at the end of August to just over 15 basis points this morning. Any further reaction from the credit markets would likely require more than just the announcement of “Operation Twist” – whereby the Fed extends the duration of the securities it is holding on its balance sheet. For Treasury yields to move even lower, we probably need the Fed to cut interest rates for banks’ excess reserves held with it to try and boost lending in the economy, QE3 and explicit employment/ growth targets to cause another big move. In the absence of this - and if the Fed only fulfils the markets’ expectation for Operation Twist - then we may find that the market reaction to this evening’s announcement (due at 1915BST) goes one of two ways: 1, muted, 2, dollar positive/ commodity and equity market negative. Either way, the weight of the markets’ expectations is on Ben Bernanke’s shoulders today.

• The dollar index is currently trading around 77.00, a less aggressive Fed could see it move towards 78.10 – the 38.2% Fib retracement of the Jan 2011 high to the early May low.

• Although the Fed is in focus, Europe’s issues are still front and centre. The IMF/ EU and ECB had a conference call yesterday that was deemed constructive. The Greek government will hold a cabinet meeting later today to discuss public sector reform. The Troika will resume their review of Greece in October, after pulling out three weeks ago after another budget hole was uncovered in Athens. This suggests we have stepped away from the edge of a Greek default, and it also suggests that the Troika have changed their tack with Greece and is now urging public sector reform rather than reform of the tax system, which was always going to be a tough ask for a nation that has tax evasion coursing through its veins.

• Italy’s reforms to promote growth announced yesterday are attracting criticism. A road from Rome to Venice isn’t going to solve the nation’s massive growth challenges that make the current public sector debt levels look like small cheese in comparison to the major problems that lie ahead, such as the ensuing demographics crisis. This plan is unlikely to reduce pressure on Italian 10-year bond yields that remain at 5.7%.

• Global growth fears have resurfaced. The downward revision to the IMF’s global growth forecasts, particularly in the developed world, along with a warning from mining giant Rio Tinto that its customers had been delaying shipments in the face of such economic uncertainty suggests two things: 1, the Fed should be aggressive in its policy support today and 2, if they are not then stocks will find it very tough to stage a meaningful rally. This should keep the pressure on commodity prices, and copper in particular.

• A UBS board meeting is expected to support the CEO – even after the trading losses announced last week.

• Also, media reports suggest that the Bank of China has stopped trading FX with some European banks. This is also likely to weigh on European stocks.

Market Action:

• Stocks are set to open modestly lower. The markets are likely to remain in a very tight range today until the FOMC later. An aggressive Fed is likely to cause a risk-on environment, if the Fed disappoints then expect a sell-off in risk, which should be good news for dollar bulls.

• Watch Europe and news out of Greece, in particular as the situation there remains fragile. EURUSD is trading in a tight 50 pip range this morning with 1.3674 the low while 1.3723 is the high. We are fast approaching 1.3650. This is a key level as it is the 61.8% retracement of the January 2011 low (1.2870) to the May 2011 high (1.4940). A breach of here may see us back to 1.3600.

• The pound will be in focus at 0930 BST as the Bank of England releases the minutes from its meeting earlier this month. Expectations are building that the Committee is moving towards another round of QE – which is broadly negative for the pound. The markets will be looking to see if any other member has joined Adam Posen in voting for more QE. Also remember that since the September meeting the economic backdrop has deteriorated and Europe’s debt crisis has notched up a gear, which is likely to keep the doves on the Committee in the ascendency for some time yet. GBPUSD looks vulnerable, below 1.5675 the next support level lies at 1.5620 ahead of 1.5580.

Source: Forex.com

21.09.2011