In recent months there has been much speculation about if, when and how the US Federal Reserve would bring to an end its second round of quantitative easing (QE2). In a historic post-FOMC meeting press conference on 27 April, Chairman Ben Bernanke shed further light on some of these questions. In doing so, he painted a near-term direction for US monetary policy, and by consequence, equities, commodities and currencies.
The important words from Bernanke's speech
- The Fed committed to maintaining its stimulation of the economy for at least a little while longer by re-investing the proceeds of maturing securities, thus conserving the size of the balance sheet.
- Bernanke was not specific on how long this re-investing might occur but suggested it would depend on future inflation and growth data.
- While slightly downgrading the Fed's growth projections and raising its forecast for inflation, Bernanke reiterated that the current food and energy inflation pressures were, in his view, "transitory", and that underlying inflationary pressures remained relatively subdued.
What the market thought
- Some market observers had worried that Bernanke might fail to deliver a clear direction for the Fed and hence create unwanted uncertainty and volatility in the market. This was not the case and financial markets were generally comfortable with what they heard.
- It correctly concluded that the long commodities/short USD trade that has greatly benefitted equities over the last 12 months still had some way to run.
- While the Fed will eventually cease reinvesting maturing proceeds (to allow its balance sheet to contract), it is generally acknowledged that the official cash rate will continue to remain unchanged for an "extended period", which probably translates into "sometime in 2012".
- As various commentators have said the 'Bernanke Put' is alive and well, and some have even suggested that with the lower growth projections the Fed has effectively opened the door for further QE measures which will undoubtedly support risk in the short term.
Is there any reason to be holding US dollars?
Debt and the downtrend of the dollar
The continuation of implied support for the US economy saw the USD hit fresh 3-year lows with investors rushing into risk currencies and precious metals. It is hard to see what is going to cause a change in the clear downtrend that has developed. The USD is pivotal to pretty much all asset classes at present with a weaker dollar pushing up precious metals, base metals, oil and subsequently equities. Concerns over the US fiscal deficit (with no credible plan to effectively reduce this over the medium term) have seen traders pour into gold, silver and currencies such as the AUD, SEK, EUR, GBP and NZD as an alternative to holding USDs.
On 16 May the US has to make a decision to raise its debt limit; a failure to do so means it would not be able to finance certain operations and this would be taken negatively.
The selling of USDs and treasuries
The fact that we have seen China wanting to diversify out of USDs and treasuries and look to hold other currencies is key and an important reason why gold has been rallying. We recently heard that PIMCO (the world's largest bond manager) had sold all of its US treasuries as it feels there will not be the demand to support prices once the Fed stops buying later this year. All of these factors have, and should, continue to hold the USD back.
We do know that the world is extremely short on the USD at present, so an event such as a change of language from a Fed official or strong US economic data could see a short covering rally. However, with current news it is hard to see any positive traction for the USD in the short term.
Where does it leave the AUD?
There are a record amount of speculative long positions in the AUD/USD suggesting we are at the mercy of profit taking. However, with our strong terms of trade, growing economy and the highest yield in the G10 complex, Australia should continue to attract foreign capital and at the very least this means any AUD pullbacks will be supported. Though, while the strong AUD bodes well for purchasing power, it is a forceful headwind for the equity market and over the next month we should see a number of companies downgrade future earnings expectations.
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Updated 29/04/11
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