The Federal Reserve’s ‘QE infinity’

So in the end, yes, last week even the US Federal Reserve decided to grant its ‘happy hour’to the delight of those investors mostly geared into risky assets. Equities rallied, gold was at fresh six and a half month highs and even in the Forex markets support tended to go for those currencies usually perceived to bear additional risk as the dollar weakened.

Essentially, among other things, the Fed decided to embark on another round of asset purchases, or as we have come to know it, quantitative easing (QE). In simple terms all QE does is increase money supply by the buying of government, or other, securities with the aim of increasing lending and liquidity. This newly announced programme increases the pace of purchases by $40 billion per month, bringing it to a total of $85 billion on a monthly basis.

This additional amount, compared to previous rounds, looks moderate but one should note that this programme is open ended, does not hold a maturity date and will persist until the labour market outlook improves – hence the markets’ nickname ‘QE infinity’. Also the asset purchases will be exclusively focused on the Mortgage Backed Securities (MBS) aiming at driving down mortgage rates and to try to encourage a recovery in the real estate market.

So far so good, but markets started sobering at the start of this week and while Spain’s issues were temporarily on the back burner ahead of the past EZ events and the Fed last week, it quickly regained the limelight. Investors tend to elevate new concerns as market euphoria starts to fizzle out.

Spain appears to be facing a catch-22. After the pressure of rising yields eased, following the measures announced by European Central Bank president Mario Draghi earlier this month, it seems that Prime Minister Mariano Rajoy’s reluctance to ask for help could easily lead yields higher again. We saw benchmark 10-year Spanish yields go lower from 6.894 per cent to 5.632 per cent after the ECB’s announced plans, but Spain’s unwillingness to ask for help has seen yields go back to six per cent levels earlier this week. Remember yields represent the cost to the issuer of that debt and the higher they go the more expensive it is for Spain to borrow.

The ECB’s announced programme for help is conditional to participation in the EFSF/ESM programme, so unless Spain is ready to submit to the pains of such a programme the ECB will not come in to help Spanish yields.

Headlines continue to suggest that the country is not yet set to take on a fully fledged bailout and in the meantime the clock continues to tick for ailing Spanish banks. The Spanish Government’s inability to lend them a financial lifeline leads us to think that it’s only a question of time before Spain will have to ask for help. Rajoy tries to buy time, reluctant to add more pressure to the debt burden his country already has. Spain would prefer if the money be lent directly to the banks but that could only happen if the plans for a eurozone banking authority take shape quickly.

Last Tuesday Spain successfully managed to auction off fresh issues of debt but given they were short term (when it comes to maturity), a better test will be the expected debt issues for the three-year and 10-year bonds due today.

EUR/USD price moves have continued in line with our expectations, as outlined in my August 30 article, (when the price was still around 1.25 levels), the price hit 1.30 levels and went beyond marking fresh four-month highs at 1.3172 up to the time of writing. For the current week we expect resistance at 1.3274/1.3428, while in case of downside support should cap moves lower at 1.2860/1.2601.

After the ECB’s and the Fed’s input earlier this month speculation of more central bank action continues for the Reserve Bank of Australia and even the Bank of Japan.

Last Tuesday minutes released for the RBA’s September 4 meeting showed that the Australian central bank could be easing further, if growth expectations continue to be threatened. The BoJ that was expected to announce its policy decisions on Wednesday also looked prone to easing in response to the persistent strength of the Japanese yen.

Upcoming FX key events:
Today: German Producer Prices, UK Retail Sales, EZ Consumer Confidence and US Philadelphia Fed.
Tomorrow: UK PSNB, Canadian CPI and Wholesale Sales.

Technical key points:
EUR/USD is bullish, target 1.3350, key reversal point 1.2550.
EUR/GBP is neutral.
USD/JPY is neutral.
GBP/USD is bullish, target 1.6400, key reversal point 1.6100.
USD/CHF is bullish, target 1.00, key reversal point 0.91.
AUD/USD is neutral.
NZD/USD is neutral.

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Mr Muscat is a senior trader at RTFX Ltd.