Three Potential Outcomes One FOMC Winner

In the past 24-hours the market has dealt with 1.25 CHF peg rumor, a weak German ZEW print, an Italian downgrade, an IMF growth cut and a dovish BoE this morning. You gotta believe it’s easier to predict what the FOMC will deliver this afternoon.

Today is Fed watch day and one of three scenarios is expected to occur. Fan favorite, the Fed will extend the duration of its Treasury portfolio, buying longer-dated notes, financed by the sale of front-end paper, other wise know as “Operation Twist”. Coming in second and third respectively, albeit a tad more aggressive, is the Fed announcing a cut in the interest rate it pays on reserves (IOR) from +25bp to +12.5bp, or new outright securities purchases (QE3).

How is the dollar expected to perform? “Operation Twist” should be generally supportive for the USD, mostly relief that Bernanke did not go for a more ‘aggressive outright purchase strategy’. If risk sensitive assets were to react negatively to the limited nature of the easing, that dollar bid should remain. Adding IOR to “Twist”, could reduce any dollar knee jerk rally, however, the market does not seem to see it as ‘substantially helpful for risk sentiment’. The QE3 approach would likely boost risk sentiment and hit the dollar broadly. Time to place your bets!

US data yesterday produced contrasting outcomes, with housing starts falling-5% to +0.571m and building permits advancing by +3.2% to +0.620m. Analysts note that the decline was reported mainly in the North east and the South, very much inline with hurricane Irene’s path. The data’s movement is insufficient to have anything more than a marginal affect on GDP. Digging deeper, the year over year data shows starts down by -5.8% overall and -2.3% for ‘signals’. Last months decline explains most of the y/y fall. The y/y permits with a +7.8% rise are ahead of the monthly gain, which analysts suggests a modest underlying uptrend.

The dollars is higher against the EUR -0.20%, GBP -0.57%, CHF -0.63% and lower against JPY +0.11%. The commodity currencies are weaker this morning, CAD -0.13% and AUD -0.22%.

The loonie started the week under water outright and looks like threatening parity again. A day after dropping the most in a month on further Greek default rumors, the loonie steadied with help from higher oil prices and a positive tone in global equity markets. The pair was little moved after data from both sides of the U.S.-Canadian border, with investors in wait-and-see mode ahead of today’s FOMC announcement. Canada’s leading indicators registered a flat reading last month, missing expectations for a +0.2% month-over-month advance. In contrast, Canadian wholesale trade figures for July (backward looking) showed a +0.8% rise on the month, just shy of the +0.9% the market was expecting.

In the leading indicators, six of the ten components advanced in August. As expected, both housing and equity markets weighed on the results, recording declines of -0.7% and -2% respectively, while new-orders rose +3.4%, a second consecutive month, as manufactures began to recover from a series of supply chain disruptions.

Governor Carney continues to apply the expected ‘dovish’ tone on the Canadian economy, explicitly noting ‘the need to withdraw monetary stimulus has diminished’. The Governor is becoming more concerned about global growth, especially now that the IMF has revised their growth forecasts. Investors are better buyers of dollars on dips (0.9938).

In the o/n session the AUD has pared some of its initial losses after leading economic indicators rose in Australia and China. The Westpac Banking Corp. of future economic growth gained +0.5% in July to print 284.2, a second consecutive monthly gain and the strongest in five-months. A leading index for China also climbed, adding to evidence that the world’s second-biggest economy is withstanding Europe’s debt crisis and faltering growth in the US (+0.6% to +158.6 in July). China is Australia’s largest trading partner. A more hawkish tone from the RBA minutes continues to push bond yields higher across the curve. Longer dated securities yields have rallied +6bp.

Despite Euro policy makers indicating that they are making some good progress with Greece, periphery yields remain elevated, heightening debt default uncertainty and requiring the paring of higher yielding risk portfolios ahead of the Fed announcement. Other negative data has also pressured the currency this morning. One of Australia’s mortgage insurers reported the percentage of mortgagees experiencing stress rose to +25% in July from +21% in June even as rental vacancies fell. Now that the domestic data is coming out a bit negative, there will be some questions ahead on what will happen to the Aussie economy. If anything, the RBA is likely to be on hold for an extended time, allowing investors to sell higher yielding assets on rallies in the short term (1.0262).

Crude is lower in the O/N session ($86.51 down-0.41c). Oil prices increased yesterday for the first time in three-days on speculation that the Fed will take steps to boost the US economy at today’s FOMC meeting, increasing fuel consumption.

Last week’s EIA inventory report revealed that crude stockpiles decreased by -6.7m barrels to +346.4m, above the upper limit of the average range for this time of year. On the flip side, gas inventories moved up by+1.9m barrels (the biggest gain in three months), after increasing +200k barrels in the prior week, and are above the upper limit of the average range. The market had been expecting gas stocks to ease by-500k barrels. Fuel use fell -3.8% to +18.7m barrels a day. Refineries operated at +87% of capacity, down -2.3% points from the prior week.

Last week’s big crude drawdown was discounted because of tropical storms which reduced production. With the ongoing weakness of gas consumption crude remains better offered on these rallies.

Now that we have margin liquidation requirements out of the way, the gold market can again concentrate on default fears. The yellow metal rallied for the second consecutive day yesterday, as European debt concerns and prospects for more steps by the Fed to bolster the US economy spurred demand for the precious metal as an alternative investment. Before yesterday’s trading, the commodity had risen +25% on the year and it is in its eleventh bull year. In reality, the continued concerns over euro-zone sovereign debt are likely to drive gold higher before policy makers are forced to take more effective action. Some analysts believe that $2,000 a once is possible before year-end.

Technical analysts believe that commodity prices have recently undergone a strong correction, followed by a decent consolidation and particularly as European sovereign concerns remain. Investors are guessing that the Fed will be required to ease monetary policy in answer to stimulate their economy. The Fed’s efforts to drive interest rates lower to support lending and by default support commodity prices even further ($1,808-0.60c).

The Nikkei closed at 8,741 up+20. The DAX index in Europe was at 5,510 down-61; the FTSE (UK) currently is 5,345 down-18. The early call for the open of key US indices is higher. The US 10-year eased-3bp yesterday (1.96%) and is little changed in the o/n session.

Treasuries yields have fallen further out the curve ahead of today’s FOMC decision. Investors are trying to stay ahead of the Fed announcement and increased their own personal holdings of longer maturities in anticipation of Bernanke and his policy makers implementing “Operation Twist”, where they buy longer dated securities financed by the sale of shorter debt.

Yesterday, Treasuries were able to erase all of their earlier declines and then some after the IMF lowered its global growth forecast, citing Europe’s sovereign-debt crisis and a potential American fiscal impasse. The priority trade in the market continues to focus on capital-preservation. With the S&P Italian sovereign credit downgrade and rumors that the ECB was again in buying Italian bonds is keeping short dated security firmly rooted to their record lows.

The market is now in a wait and see pattern with Ben and his companions. Delers do not like surprises!

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