The U.S. dollar remains at the mercy of policymakers. A meaningful response is needed to trigger a downside reversal in the greenback.
As “operation twist” will not impact the size of the Fed’s balance sheet, it did not translate into dollar weakness. The lessons from 2010 suggest that it is probably a matter of time before such a policy (i.e. QE3) is deployed. Recall, following the end of QE1 in March 2010, the U.S. economy started to weaken and the equity market began to tumble. The Fed’s initial policy response in early August 2010 (reinvesting maturing debt into new Treasurys) was not enough to placate markets and the dollar strengthened. Just a few weeks later Fed Chairman Bernanke suggested that QE2 was in the works. The 2011 policy roadmap is eerily similar, especially after the latest two Fed meetings left markets underwhelmed. But until QE3 is credibly articulated by Bernanke, there could be more downside for risky assets and further upside for the dollar. Apart from the Fed, efforts by European officials to stem their sovereign debt crisis and an end to Chinese tightening would also go a long way to supporting global growth and stabilizing risky assets. Our Foreign Exchange Strategy closed a number of short dollar/pro-cyclical trades for modest profits as the trailing stop-losses were hit. For now, stick to defensive trades (short USD/JPY and EUR/JPY) as they will benefit if the “risk off” environment persists.
George.
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