Fed Twists, Markets Shout and Some Thoughts on Currency Levels

The Federal Reserve announced Operation Twist and rather than increase investors appetite for riskier assets, the market has sought the security of the US dollar and to a lesser extent the Japanese yen. Equities have dropped dramatically, but the impact of the Fed's plans is clear as the US Treasury curve continues to flatten with the long end rallying in anticipation of the Fed's purchases.

It did not help matters that the euro zone flash Purchasing Managers survey was dismal. The manufacturing PMI fell to 48.4 from 49.0 in Aug and the non-manufacturing PMI dropped to 49.1 from 51.5. The composite reading of 49.2 is the first below 50 and lowest since July 2009. Although it is not in most base line forecasts yet, the risks of a new contraction in Europe is rising, even while it appears Q3 will be near trend (2.5%-3.0%) in the US.

Adding insult to injury, the euro zone reported industrial orders in July fell 2.1%, nearly twice the decline the consensus was looking for. If there is a bright spot in the euro zone today it is Ireland. While my earlier posting on Ireland met some skeptics, today the Emerald Isle reported Q2 GDP at 1.2% (quarter-over-quarter). The consensus was for around a a 0.3% increase. And Q1 was revised up to 1.9% from 1.3% initially report. The year-over-year growth stands at 2.3%. Q1 was revised to 0.3% from 0.1%. Moreover, the current account deficit also shrank more than expected.

Yet the Irish growth story is buried today by the euro zone data and also China's disappointing HSBC flash PMI, which fell to 49.4 from 49.9, for the the third consecutive month below the 50 level. The details are also worrisome with new orders and new export orders moving below 50, while the input price index rose to a four-month high just below 59.

The Fed's announcement has stolen the headlines, but what the ECB announced yesterday should not be lost in the shuffle. The ECB took two actions. First it announced debt instruments issued by banks, other than covered bonds, need not trade in regulated markets to be acceptable as collateral. By increasing the range of eligible collateral, the ECB is making it easier for banks to borrow from the ECB.

The ECB did not want to fully open the flood gates apparently and its second action tightened another rule. Currently banks can use its own unsecured debt as a collateral with the ECB but it cannot be greater than 10% of the total value. That will be cut to 5%.

It is tempting to think that these measures are preemptive in nature like the recently announced 3-month dollar auctions. However, these new ECB measures do not go into effect until January 1. It underscores a criticism of the ECB, and Europe in general. It lives in an analog world, while the market, investors and events have gone digital.

Turning to the Fed, it announced an active Operation Twist, reducing its holdings of short-term Treasuries (under 3 years) and buying longer-term Treasuries (6-30 years). The $400 bln operation will push the average maturity of the Fed's portfolio to about 100 months by the end of next year. The operation is 9-months long and will be completed by the middle of 2012. The amount seems a bit more than expected, perhaps in part because, the Fed also announced it would cease rolling its MBS proceeds into Treasuries and instead keep it in the MBS space, to ostensibly support the housing market.

On balance, a Reuters survey of suggests, primary dealers are not confident that these measures will suffice. Nearly a third expect more dramatic action, ie QE3, over the next 6 months and about the same expect the US economy to experience a new contraction.

With the 3-person dissent bloc still making its feeling known, it is clear that once again the Bernanke Fed is willing to sacrifice a consensus of regional presidents for action, even if the economic impact is likely to be muted. It is difficult to see how Operation Twist will spur employment.

Price Action

Euro: Posted an outside down day yesterday and the followed through to the downside today. It is at the lowest level now since Jan, and the Jan low, which is the low for the year, near $1.2865, is the next big target, though of course the $1.30 level looms first of psychological import. The implied volatility is near 17.5% currently. Vol has increased as the euro has slid. Even though the specs at the IMM are short euros, the relationship between vol and the spot action warns that a falling euro is still the pain trade for the larger market. The $1.35-$1.36 area should offer important resistance now.

Sterling: Trading at new lows for the year today. The CBI industrial survey was twice as weak as the consensus expected (-9 vs -5 consensus and +1 in Aug). It can only fan the expectations of BOE easing. The $1.50 area beckons, though initial near-term support is seen near $1.5275. Before the end of the year, I suspect we might see the $1.4850 area.

Yen: I have little insight with the dollar trading between JPY76-and JPY78. Japanese officials seem to recognize that yen strength is a function of international considerations. This would seem to play down the risk of intervention but extending its asset purchase program remains a possibility. Over the past five sessions, the yen is the only major currency to advance against the dollar (0.5%).

Canadian dollar: It has been simply crushed. It is as its lowest level of the year and the dismal July retail sales report (-0.6% vs -0.3% consensus) raises the likelihood of an BOC rate cut in Q4. There is scope toward CAD1.05, while the CAD1.03 area should offer initial support to the greenback. A word of caution however is in order as the US dollar is trading now 3 standard deviations above its 20-day moving average. Rarely does it trade 2 standard deviations away. This does not mean the Loonie is a buy, but rather than the momentum is unlikely to be sustained.

Australian dollar: It has also broken down and is approaching the lows for the year, which were set in March just above $0.97. Weaker Chinese data more than offsets RBA comments about the resilience of the Australian economy. The Aussie is about 2.5 standard deviations from its 20-day average. Parity might be the most to expect on a bounce.

Misc: The weakest currencies against the dollar over the past five days have been the dollar bloc, the Scandis and the Swiss franc. The last of has been fueled by speculation that the SNB will lower ceiling for the franc (raising the euro to CHF1.25 from CHF1.20). The weakness of the others is more typical of the experience in 2008 and 2009. In addition to being perceived to be levered to global growth, the market may also be reacting to shifting policy trajectories. Lastly, emerging market currencies are also falling hard. This may in part be a prompted by the liquidation to cover losses or draw downs elsewhere. It does cast doubts over the de-coupling story that had begun gaining traction action.

Cash is king and the dollar's safe haven status, when everything is said and done, remains in place in extremis.