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Friday October 22, 2010 - 16:13:58 GMT
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Turn Page on G20, Go Directly to November 03 FOMC Where Size Matters (FXA)

You need not be a clairvoyant to know that G20 this weekend will lead to no major policy changes in respective countries to reduce imbalances.  It is all about LCD…milquetoast language on the goal of reducing imbalances with the appropriate policy mix and to oppose excessive FX movements that threaten growth while agreeing to cooperate in exchange markets.  In other words it is all about papering over major splits on all key issues…emerging currencies in need of revaluations against developed (economies) currencies, correcting large external imbalances with domestic policy measures in addition to FX adjustments and stabilizing the USD.  The only bargain to be struck in Gueongu this weekend is in the basement of E-Mart


So turn the page and go directly to November 03 when the FOMC will announce its much anticipated decision on QE2.  With stocks struggling on the upside and the USD struggling on the downside this week, there has been a marked increase in chatter of the Fed going small on QE2 as a bone to toss for the weak dollar handwringers at G20 and to check risks of contributing to a new bubble in asset prices here and in ROW.  I will leave small to others to define though it is surely well south of $500bln in the initial salvo or iteration. 


I have a problem with the whole discussion of size…yes it fully matters, but it is unknowable…a known (QE2 will happen) unknown to quote the former US Defense Secretary Rumsfeld.  How can we reasonably predict something the Fed will do when the Fed does not have a clue on how much it will do in the next 12 months?  Moreover, the Fed has no clue about its impact apart from a few studies and one of which generated a rough rule of thumb that $500bln pushed 10-year yield down 50-75bps.  The reality is more akin to an experimental trial for a new drug but instead of the administrators handing out real doses and placeboes the Fed can’t tell the difference between the two (double blind?).  The operative word is experimental.  Here is what I said last night on The Kudlow Report  on CNBC (about 1 minute in).


We can make educated guesses about the first iteration on November 03 but beyond is really in the unknowable.  I think Evans defined big and perhaps what markets have discounted…$100bln a month and open ended…if run for 12 months $1trln (first QE was $1.2trln and that was considered shock n’ awe and done much quicker than what Evans has in mind).   Surely the pro-QE2 camp at the Fed wants to be able to adjust the monthly QE2 on an as-needed-basis on incoming data on everything from the real economy to bank lending (and asset prices).   Unknowable.


But the more important bet on the first iteration is whether the Fed is really looking at the dollar since late August and asset prices and concluding oh man we can’t endorse this kind of activity.  I got news for the go small camp…these outcomes are precisely what the QE2 FOMC consensus desires and furthermore the decline in the dollar since late August has been anything but disorderly…heck it has helped stocks rally as markets discount higher earnings for US multinationals.  And a glance at the US Treasury market for signs of stress from a loss of confidence in the USD is nowhere to be seen…not at auctions, not between auctions and surely not with the Fed preparing to buy US Treasuries. 


Lastly, the whole idea of QE2 is to try, in a very experimental way with unknown intended and unintended consequences, to impact the real economy at a time when fiscal policy stimulus is drying up and could tighten in January unless Congress and the President extend the Bush tax cuts.   This does not strike me as something the Fed does cautiously or in modest increments.  The Fed is sure to err on the side of big not small ahead and is confident it can exit (neutralize) asset purchases quickly and efficiently if the operation proves highly potent.  So at the very least the Fed will have to meet expectations on the first iteration of $100bln a month or the Fed will send a message to markets that it is not inclined to see large gains in risk assets and USD declines linked to QE2.  Does the Fed really want to unwind stock market gains in the US to get China to revalue its yuan at a faster clip for an even more intangible result on US economic activity?  I think not.


Regarding the dollar (and stocks), additional downside ahead of the FOMC meeting short of more direct and indirect messages from the Bernanke camp on the FOMC next week of big is better we think the dollar is likely to consolidate under 1.40 vs EUR and could dip a little more as the go small supporters find some traction, but look for new USD lows following the FOMC meeting as markets come to terms with a large first salvo and the potential for an even larger dose later should the economy demonstrate more weakness.  Moreover, we should not lose sight of where the ECB is headed…policy for Germany and not the periphery with the phasing out of unconventional and an early focus on normalizing interest rates which favors the long EURUSD trade through the end of the year at least.


David Gilmore



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