FED is tangled up in uncertainty

Outlook:

Not to put too fine a point on it, but yesterday, Draghi spoke beautifully. Every-thing he said was perfectly clear. He was relaxed, charming and utterly convincing. VP Con-stancio was also clear, zapping the WSJ reporter with a sophisticated answer about why infla-tion is being sought. It’s a joy to watch a Draghi press conference, whereas it’s an ordeal to watch a Fed press conference, and not just because Yellen has an annoying tone and accent. The difference lies most-ly in the presenters’ attitude. Draghi and Company are confident in their work and respond to criticism without rancor or anxiety. The Fed, on the other hand, is perpetually on the defensive. The Fed’s seem-ing confidence comes off as stubborn arrogance rather than authentic poise and composure. Draghi real-ly is Super Mario.

The bottom line: the ECB staff will come up with revised forecasts for the Dec policy meeting and the committee will decide then whether to enlarge, prolong or change the composition of QE depending on what that data shows. Draghi made it clear that the bank lending, consumer and business confidence, and other factors are okay—it’s inflation and inflation expectations that will dominate the decision-making. The ECB is willing to see short-term changes as temporary and based mostly on energy costs. It’s the longer-term outlook that counts. Inflation recently went from +0.1% to -0.1%. Draghi needs to see it moving back up again and preferably on a rising trajectory toward the target 2% if the ECB is to avoid taking additional action. Draghi also called for “structural reform,” by which he means fiscal spending, although he is unlikely to get it.

Again, this is clear and understandable data-dependency, whereas the Fed’s data dependency is mushy. So, it’s a pretty good bet that QE is indeed going to be enlarged/expanded. If we believe the divergent policy scenario in which the ECB is cutting and the Fed is hiking, the euro should indeed fall and fall some more. On the monthly chart below, the euro has already broken the final 62% Fib level and can go all the way to the 100% retracement line at 0.8229, the lowest low from October 2000.

But there has been a lot of water under the bridge since 2000. Super long-term charts like this are certainly very interesting, but it is by no means a clear process by which fundamentals operate on trad-ers’ minds to result in exchange rates that somehow reflect economic reality. Which economic reality? Since this chart started in 2000, we have had 9/11, two wars, the 2008 crisis and Great Recession, the rise of China, and a dozen other big-picture changes, including oil at $145 and then $20 and then $100 and now $50. In a nutshell, we draw these charts but we hardly ever get any useful insights from them. It’s possible hedge fund managers and perhaps some others enjoy these charts and make decisions based on them, but day-to-day traders do not. They trade what is in front of them.

This is a critical point, because sentiment favoring the euro has a long history of poking its head back up. And anti-dollar sentiment has persisted periodically since the late 1970’s. We could get a ceiling on the euro’s rise instead of a retreat to an old floor. Notice that support and resistance on the monthly chart meet at around 1.2810.

Still not getting any real attention is the very real possibility Congress fails to raise the debt ceiling and we spiral into a sovereign debt crisis. Market News reports that BMO sees Oct 27-29 as the “key action dates” during which volatility could surge. A credible bills needs to reach the President’s desk by Oct 29.

We should probably assume that Draghi’s unambiguous policy statement will indeed lead to further QE of some sort, any sort, in December. Let’s further assume the Fed is tangled up in uncertainty and does nothing in December but keeps the door open for some action at some time in Q1. Unless we get a sov-ereign debt crisis in the US, the policy divergence story can gain serious traction. That almost certainly means the euro downmove will continue. But we are never comfortable with a rising dollar forecast—history tells us dollar rallies are weak.