The 4Xlounge Market Insights discusses a number of the most significant economic developments that directly influence the trends found in the Forex market. Ideally we strive to identify the strongest directional movements that emerge so that we may isolate those trades with the highest probabilities of success over the long run. Today we will focus our attention to the US and its recent central bank meeting.
The Federal Open Market Committee (FOMC) met yesterday afternoon as it was announced that interest rates would remain at record lows for an extended period of time. Furthermore the ‘Fed’ determined it appropriate to extend its current round of stimulus known as “Operation Twist” (O.T.) throughout the remainder of the year, 2012’. In this stimulus measure the Fed agreed to purchase an additional 287 billion worth of treasuries with long-term maturities and sell an equivalent amount of shorter-term maturity (securities) to fund those purchases. This is done to maintain pressure on long-term interest rates, which the Fed hopes will encourage consumers to put their capital to work in the form of ‘big ticket items’ such as in the housing market. As the USD currency tends to move in the same direction as interest rates, the continuation of record low borrowing costs may help contain the USD and prevent the chances of a substantial rally. However the continuation of Operation Twist can be considered a compromise as some did speculate the Fed would initiate a more aggressive measure of stimulus in the form of Quantitative Easing III (Q.E. III), which many traders anticipate would have led to further selling pressure on the USD.
Let us now take a closer look at the Fed’s justification of low rates and the continuation of Operation Twist putting to work the very same economic barometers the central bank uses to establish interest rates. Specifically the Fed has stated their decisions are based in part on a number of economic figures including the Gross Domestic Product (GDP), which measures the rate of growth in the economy as well as the Personal Consumption Expenditure (PCE) that measures the rate of inflation in addition to the ‘Core’ PCE, which excludes the more volatile components of inflation such as food and fuel.
Taking the average of these three figures produces the “Average Economy” line (shown below), which simply reflects the current strength of these figures. For example, the most recent data shows that US GDP on a Quarter-over-Quarter basis rose at a rate of 1.9%. At the same time the PCE & Core-PCE increased at a rate of 1.8% respectively. Calculating the average of all 3-figures produces a reading of 1.83, shown below along with the Dow equity index. (Average Economy of 1.83 = (1.9 + 1.8 + 1.8) / 3).
We can see here how the economic data did improve under the influence of Q.E. & O.T., but notice that during the latest rounds of stimulus, while the Dow did enjoy a significant rally to the upside, the actual economic figures did not necessarily reflect the same degree of strength. Perhaps this tells us that stocks are relatively ‘over-valued’ as the index continues to exceed the rate of growth in the actual economy.
We may also consider the relationship between the various rounds of stimulus as its effects can be seen within the economic numbers as well as the USD currency. Notice below that during both rounds of Quantitative Easing (I & II) the economic data did substantially improve while the USD actually moved sharply lower. We can attribute this negative (opposite) correlation to the fact that Quantitative Easing involves the purchase of treasury securities that is funded through the ‘printing of new dollars’, while Operation Twist involves simply moving that investment capital from shorter-term to longer-term treasuries, and does not require the creation of new capital, which has been known to dilute and weaken the USD. In other words, while the divergence between the ‘economy’ and the Dow still persisted during Operation Twist, the USD/CHF and the economic data no longer experienced the negative correlation as it once did.
What may we take away from this? The multiple efforts taken by the Fed did in fact result in stronger stock prices, and to a lesser degree a general improvement in the economic conditions. However we can also see the negative effect Quantitative Easing exerted on the USD, and a more neutral result under the influence of Operation Twist. Traders now ponder the outcome as a result of the extension of Operation Twist through the remainder of the year. Will stocks continue to respond favorably to stimulus, or does the recent weakness in the equity market reflect the growing immunity to the central bank’s activities? More importantly, if equities do not respond favorably to the additional Operation Twist and in fact sell off, does this create a case for a strong USD rally? Perhaps this is especially true due to the fact that only Quantitative Easing has proved to be a negative to the USD, and not Operation Twist because of their inherent differences in ‘where’ the capital is coming from? But the combination of poor economic data, weak stocks and a strong USD has its own risks. Perhaps if the economy deteriorates enough this may in fact justify another round of Quantitative Easing and in turn, create a significant deterrent to the USD buyers. So at least in the case of the USD, we might come to the conclusion that ‘from bad can come good, unless the bad gets much worse’.
We wish you the best of luck in all your trading endeavors.
Sincerely,
Adam Rosen
The Federal Open Market Committee (FOMC) met yesterday afternoon as it was announced that interest rates would remain at record lows for an extended period of time. Furthermore the ‘Fed’ determined it appropriate to extend its current round of stimulus known as “Operation Twist” (O.T.) throughout the remainder of the year, 2012’. In this stimulus measure the Fed agreed to purchase an additional 287 billion worth of treasuries with long-term maturities and sell an equivalent amount of shorter-term maturity (securities) to fund those purchases. This is done to maintain pressure on long-term interest rates, which the Fed hopes will encourage consumers to put their capital to work in the form of ‘big ticket items’ such as in the housing market. As the USD currency tends to move in the same direction as interest rates, the continuation of record low borrowing costs may help contain the USD and prevent the chances of a substantial rally. However the continuation of Operation Twist can be considered a compromise as some did speculate the Fed would initiate a more aggressive measure of stimulus in the form of Quantitative Easing III (Q.E. III), which many traders anticipate would have led to further selling pressure on the USD.
Let us now take a closer look at the Fed’s justification of low rates and the continuation of Operation Twist putting to work the very same economic barometers the central bank uses to establish interest rates. Specifically the Fed has stated their decisions are based in part on a number of economic figures including the Gross Domestic Product (GDP), which measures the rate of growth in the economy as well as the Personal Consumption Expenditure (PCE) that measures the rate of inflation in addition to the ‘Core’ PCE, which excludes the more volatile components of inflation such as food and fuel.
Taking the average of these three figures produces the “Average Economy” line (shown below), which simply reflects the current strength of these figures. For example, the most recent data shows that US GDP on a Quarter-over-Quarter basis rose at a rate of 1.9%. At the same time the PCE & Core-PCE increased at a rate of 1.8% respectively. Calculating the average of all 3-figures produces a reading of 1.83, shown below along with the Dow equity index. (Average Economy of 1.83 = (1.9 + 1.8 + 1.8) / 3).
We can see here how the economic data did improve under the influence of Q.E. & O.T., but notice that during the latest rounds of stimulus, while the Dow did enjoy a significant rally to the upside, the actual economic figures did not necessarily reflect the same degree of strength. Perhaps this tells us that stocks are relatively ‘over-valued’ as the index continues to exceed the rate of growth in the actual economy.
We may also consider the relationship between the various rounds of stimulus as its effects can be seen within the economic numbers as well as the USD currency. Notice below that during both rounds of Quantitative Easing (I & II) the economic data did substantially improve while the USD actually moved sharply lower. We can attribute this negative (opposite) correlation to the fact that Quantitative Easing involves the purchase of treasury securities that is funded through the ‘printing of new dollars’, while Operation Twist involves simply moving that investment capital from shorter-term to longer-term treasuries, and does not require the creation of new capital, which has been known to dilute and weaken the USD. In other words, while the divergence between the ‘economy’ and the Dow still persisted during Operation Twist, the USD/CHF and the economic data no longer experienced the negative correlation as it once did.
What may we take away from this? The multiple efforts taken by the Fed did in fact result in stronger stock prices, and to a lesser degree a general improvement in the economic conditions. However we can also see the negative effect Quantitative Easing exerted on the USD, and a more neutral result under the influence of Operation Twist. Traders now ponder the outcome as a result of the extension of Operation Twist through the remainder of the year. Will stocks continue to respond favorably to stimulus, or does the recent weakness in the equity market reflect the growing immunity to the central bank’s activities? More importantly, if equities do not respond favorably to the additional Operation Twist and in fact sell off, does this create a case for a strong USD rally? Perhaps this is especially true due to the fact that only Quantitative Easing has proved to be a negative to the USD, and not Operation Twist because of their inherent differences in ‘where’ the capital is coming from? But the combination of poor economic data, weak stocks and a strong USD has its own risks. Perhaps if the economy deteriorates enough this may in fact justify another round of Quantitative Easing and in turn, create a significant deterrent to the USD buyers. So at least in the case of the USD, we might come to the conclusion that ‘from bad can come good, unless the bad gets much worse’.
We wish you the best of luck in all your trading endeavors.
Sincerely,
Adam Rosen
