Forex Investment and Currency Trading

As the FOMC begins its two-day policy meeting, focus on the impact of quantitative easing on FX is higher than ever.

Since the Bank of England adopted quantitative easing earlier this month, the market has punished the Swiss franc, pound and dollar – the three currencies where some form of quantitative easing/monetary base expansion has been adopted.

The current weakness in these QE currencies and potential for more, are different in all cases. With sterling already at weak levels, the case for a sustained, further decline is not compel ling. On the flip side, the Swiss franc began quantitative easing at elevated levels and the SNB has made weakening the currency a central part of its strategy.  As such, there is scope for further CHF downside. While on the dollar, the recent weakness is probably more linked to the improvement in risk appetite than it is with the US-version of quantitative easing. But that could change if the Fed shifts its policy focus toward buying Treasuries rather than just parts of the credit market. At present, risks of a major shift in its policy focus at the current meeting seem low, especially with the TALF program set to kick off later this week. But early indications that the private sector participation in TALF is modest alongside the perceived success of the BOE’s QE program do suggest the Fed may open the door a little bit further for eventual outright purchases of Treasuries. If the Fed does begin moving toward the outright purchase of Treasuries, it would open the door for more pronounced dollar weakness.
 
The dollar’s strength has been driven by three strong inflows since the onset of the financial crisis –

• large purchases of short-term T-bills by foreign private sector investors,
• a big rise in net dollar bank liabilities and
• repatriation of overseas assets by US investors.

On the flip side, foreigners have shown little demand for US private sector securities and have been divesting out of agency securities. In January, all of the positive flows reversed, while demand for US agencies and private sector securities remained low.

the biggest risk for the dollar is further normalization of financial markets and a bottoming (not necessarily a recovery) in the global economy. Here, the dollar positive duress flows would likely slow, at a time when foreign investors would still be cautious toward buying US private sector securities.