US Dollar maybe Bullish in QE2

On Friday, the financial markets were abuzz with the notion that Ben Bernanke stated "all other things being equal, there appears to be a case for more action." The knee jerk reaction was predictable, the US Dollar fell and bonds climbed, however, by the end of the US trading session these trends had reversed…why?

I would point to other portions of Chairman Bernanke’s speech where he spoke about the risk and rewards of unconventional monetary policy. One of the most surprising admissions by the Chairman was that he did not know the ultimate impact of QE2. From the speech,

Perhaps this was simply refreshing honesty which the market is unaccustomed too after the Greenspeak era. However, the fact remains that the Chairman of the US Federal Reserve, who did his doctoral work on the Great Depression and the deleterious impact of a waning money supply, is concerned about the unintended and unknown consequences of his actions. The financials markets have been expecting higher bond prices and a weaker dollar, but this expectation is flawed. Through QE2 the US Fed is attempting to spur financial speculation which they hope will foster real investment in property, plant, and equipment. By extension these facilities will need to be filled with workers and voila…unemployment drops.

While the market has focused in the mechanism for QE2, i.e. asset purchases, it has completely ignored the primary tool used by the US Federal Reserve…communication. Chairman Bernanke, in numerous speeches and papers, has argued that Federal Reserve policy is not limited to interest rates and money supply, he suggests that the first step for policy makers is to communicate the Fed’s intentions. If executed flawlessly, the Fed may not even need to write one buy ticket for Treasury securities. So has it worked?

The chart illustrates market expectations for inflation over the next five years; it is simply the 5 year Treasury Rate minus the 5 year TIPs rate. Without buying a single Treasury Bill, Note or Bond, the US Fed has successfully increased inflation expectations from 1.2% to over 1.6%…in less than a month. At this pace, inflation expectations will be at 2% (the Fed’s target) by the time of the November FOMC meeting. The implication is that market expectations of a massive bond buying program could be incorrect. Furthermore, if financial speculation leads to real economic investment and hiring then further QE is not needed.

Without a massive bond buying program the linchpin of the dollar bear argument disappears – the Fed will not be "printing money" and will not destroy the dollar. In fact, QE2 could be bullish for the US dollar. The Fed’s verbal commitment to support asset prices coupled with its ability to buy assets should provide support in the US financial markets. Moreover, while yields may move slightly higher due to inflationary expectations the US stock market will remain relatively attractive as compared to bonds. Therefore, from an investor’s perspective US assets become attractive. The "Goldilocks" environment the Fed is attempting to create could result in foreign investor interest in the US markets as relatively low rates and the Bernanke "put option" make the US a safer place to invest. This foreign investment interest would be supportive of the US dollar. Moreover, as other countries attempt to weaken their currency the US dollar will strengthen, making US investments even more attractive.

The simplest way to play a stronger US dollar is a long position in the US Dollar Bullish ETF (UUP). This ETF gives an investor broad exposure to dollar strength; additionally, the US equity markets may need a period of adjustment to a stronger dollar. A strong US Dollar does not always mean lower stock prices; in fact if the Fed is successful the real economy will begin to improve. However, the current market mindset is that a strong dollar is bad for stock prices. It may take some time before the markets change their view and thus the direct currency play via UUP appears to be the most attractive investment.

Disclosure: Accounts managed by Kanundrum Capital are long UUP.

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Ref: http://www.cnbc.com/id/39721929