It won’t stay that way for long, however. Next week the focus will return to the Fed as the market tries to guess which tool or tools will be wheeled out of the Fed’s tool shed.
Thursday’s firmer than expected CPI data (+3.8% y/y) makes it very unlikely, in my view, that the Fed will unleash another round of quantitative ease, adding to the Fed’s already record-large balance sheet. QE1 was timely and effective in restoring market confidence at a time when the financial sector in the US was teetering on the edge of collapse in the spring of 2009.
The case for QE2 was much less clear-cut. The Fed was concerned by declining but still positive inflation data in the summer of 2010 and wanted to avoid a Japanese-still deflation. QE2 boosted asset prices but it also dramatically boosted the cost of food and energy, more than offsetting any benefit to the average American. It also caused a sharp populist backlash against Fed money-printing and debt-monetization.
Against the present backdrop, the Fed is unlikely to crank up the printing press, instead using some of the other tools at their disposal.
I suspect the Fed will cut the 0.25% rate it pays banks on deposits of excess reserves. With 2-year Treasury notes yielding a scant 0.18%, there is little reason to pay 0.25% overnight.
They will also likely lengthen the average maturity of the debt held on the Fed’s balance sheet. They can do this by selling shorter-dated securities and buying longer-dated ones. The market full anticipates the Fed to deploy this strategy, last used in the 1960s and dubbed “Operation Twist”. If they don’t do that one, look for long-term US rates to rise sharply.
The risks next week appear asymmetric: The market has an”Operation Twist”- like program priced in. If the Fed does not deploy that program, USD/JPY, the most interest-rate sensitive USD pair, would likely be the main beneficiary.
If stocks sell-off on disappointment, EUR/USD would likely drop.