For all the criticism that the Federal Reserve’s Quantitative Easing (QE) policy has received over the recent years, it is surprising that the recent decision of QE tapering has taken so many people unawares. The Fed has now announced a taper of $10 billion, clearly underlining its confidence in the resilience of the U.S. economy.
The taper will encompass two asset types- treasuries and MBS to the tune of $5 billion each. The official start of the ‘dectaper’ is in January, 2014 and the true consequences of the stimulus reduction should become much more apparent then. Although the impact of this news on the U.S. dollar has been immediate and unmistakable, it may be a challenge for newcomers to the Forex market to truly understand why QE related decisions are such landmark events in this marketplace.
The objective of QE
Central banks often resort to tweaking monetary policy to stimulate a flagging economy. Quantitative Easing is a very common policy deployed, wherein the central bank buys long term securities, both government-issued ones and from private parties, to increase the monetary supply and cap yields. The resultant increase of capital in the hands of financial institutions promotes lending and liquidity and thus shores up a tanking economy.
In the case of the U.S. economy, there is little doubt that strong measures were needed when the Federal Reserve decided to intervene with its QE policy. However, there have been questions raised about whether the Fed should have allowed the stimulus to continue for this long. On the other hand there are also others who believe that support continues to be necessary for the still shaky economy here. For the forex trader, it is critical to understand how a gradual weaning away from this kind of Fed support will affect the U.S. economy as a whole and the strength of the U.S. dollar in particular.
There are several critical points to note in crucial decisions of this kind and it is these that impact the fortunes of the currency market:
A QE reduction or increase shows how confident the country’s banks are about its economy and the economy’s resilience.
QE measures that involve securities buying typically limit the yields. Tapering off the QE has the opposite effect and yields tend to rise. With this, the currency also tends to strengthen.
The decision to continue QE will impact the economy and currency of trading partners too. For example, a decision to continue QE will give more liquidity to U.S. markets and this is great for Canada, which is a significant trading partner. In effect, the Canadian economy and currency gains strength when the U.S. central banks decide to keep the stimulus program running. With the QE taper, it can be reasonably expected that the Canadian currency will come under pressure. However, the strengthening of the U.S. economy is also a positive for Canada so a mixed reaction may be witnessed.
‘Bare minimum’ taper prevents huge Movements in many currency pairs
The Federal Reserve has adopted a cautious approach by announcing a bare minimum QE taper. With only $10 billion worth of tapering to be carried out, it is clear that the Federal Reserve is still hesitant to completely leave the economy to its own devices. The impact of this announcement is likely to be controlled thanks to this ‘tread carefully’ approach.
In fact, this was quite apparent when the U.S. dollar moved sharply right after the announcement, but quickly settled down. However, currency pairs featuring the U.S. dollar are not completely insulated against movements. The EUR/ USD pair is weaker and analysts expect no more highs for this pair before the year end.
The USD/JPY pair is expected to show more movement by year-end, mainly because the JPY is not faring as well as expected. This, in combination with the return of confidence in U.S. markets may shift the pair significantly in favor of the Dollar. The GBP remains fairly stable and even when compared with the USD, it may be able to maintain its foothold. The predominant reason behind this resilience is the heartening jobs data recorded in the UK. Dramatic change has been witnessed only in two of the major trading pairs. The EUR/USD pair has been volatile since the QE taper announcement and it remains to be seen exactly where the pair settles. Another currency pair that has shown significant movement post the news is the AUD/USD pair, which has served to highlight that the Australian currency is losing ground.