Why the USD Soared on the FOMC Minutes

Up until the release of the minutes from the most recent Federal Reserve monetary policy meeting, it had been a very quiet trading day.  Its not often that the FOMC minutes will cause a large reaction in currencies but the fact that the dollar soared minutes after the release to a 2 year high against the euro goes to show how easily swayed investors are when it comes to signs of QE vs. no QE.  In today's case, the FOMC minutes was just not enough to satisfy QE3 traders who wanted a more explicit admission that further asset purchases would be necessary.  A few FOMC members felt that more stimulus could be needed but this wasn't any different from what they said back in April.  The same is true of the warning that they are prepared to take further action as appropriate.  While Federal Reserve officials are clearly worried about the state of the U.S. economy and the outlook for China, their call for a study on "new tools for easing" suggests that they want to look for other options beyond Quantitative Easing.  In a nutshell, the Federal Reserve isn't committing to anything and keeping all of their options open which was enough to squeeze the dollar higher.

Does this mean that QE3 is off the table?  Absolutely not.

While the monetary policy committee felt that the economy continued to expand moderately between April and June, they admitted that the gains were smaller than anticipated and there is unusually high uncertainty for jobs and growth.  Some FOMC members also believed that there could be a significant slowdown in China that could deal a blow to the export sector.  Their decision to revise down their growth forecasts were motivated by a slower pace of job growth, weak retail sales, a lower trajectory for personal income and weaker exports.  The prospect of further uncertainty in Europe and tighter domestic financial conditions also contributed to their decision to downgrade their GDP forecasts.  The FOMC minutes may have helped the dollar by shaving the chances of QE3 but we don't believe that everyone have given up on the idea of more stimulus and for this reason every piece of incoming data this week and next could still trigger big moves in the greenback as traders adjust their QE expectations including tomorrow's import prices and weekly jobless claims report.

EUR: Shrugs Off Fresh Spanish Budget Cuts

The euro fell to a fresh 2 year low against the U.S. dollar after the release of the FOMC minutes.  The weakness of the euro reflects the market's ongoing concern about growth as nothing is good enough for the euro.  The Spanish government announced new plans to cut its budget deficit by EUR65 billion which should have been positive for the euro because it reduces the risk of a sovereign bailout and puts the country closer to receiving the money that it needs to save its banking sector but the euro barely budged.  European equities on the other hand responded positively while Spanish ten year bond yields continued to tick lower.  The problem is that more austerity will only prolong the recession in Spain especially since the government plans to raise the value added tax by 3 percentage points from 18 to 21 percent.  Expectations of faster balance sheet expansion by the ECB versus the Fed seem to be the only thing that matters to the EUR/USD right now. The prospect of sluggish growth in the months to come means that there is a very good chance the ECB will have to introduce another long term refinancing operation (LTRO). On the other hand, today's FOMC minutes tell us that the bar is still high for QE3.

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