With the long await Fed decision behind, what are the likely implications of Fed's new round of asset purchase, dubbed QE2?

The Fed's announcement of $600 billion in assets was not much a surprise but the details within the statement provided fodder for global markets. If the subsequent price action can be used as a guide for the likely trajectory there are two takeaways. One, the dollar weakness should continue, at least over the very short-term as bond yields continue their descent and investors flock to non-dollar denominated assets.

Two, risk appetite should recover leading to an outperformance of higher-yielding currencies, along with currencies of faster growing economies. Therefore, in the G10 space we expect to see outperformance of NZD, SEK, CAD and to a lesser degree AUD (as its interest rate hikes continue to weigh on the economy).

Nevertheless two aspects of the QE2 announcement have captured the attention of participants. First, there is the open-ended nature of the FOMC commitment which provides an implicit backdrop for risk. At the same time the Fed seemed to emphasize the binding nature of its commitment to its dual mandate for price stability and full employment.

It is not a question of policy preferences, but a legal mandate. Without specifying how much progress toward reaching those objectives would make the Fed comfortable, it is not clear what terminates the policy.

Second, the amount of Treasury purchases between the QE2 and the recycling of mortgage bond holding maturities, the Federal Reserve is committed to essentially buying the complete new net issuance in the coming months. Although the Fed's signaling and market expectations would have led to this conclusion, many seem surprised. What is less commented on, but what seems remarkable is that most high income countries would welcome the Fed's base line GDP and inflation forecasts for their own economies, but for the Fed it is not good enough.

The key driver of major currencies, going forward, will be economic fundamentals and divergence in fiscal and monetary policy. Therefore, the market will be leaning on economic data as the gauge to whether the Fed (and to a lesser degree) other central banks will provide liquidity to stoke price appreciation - i.e., higher inflation.

Trichet's speech this morning highlighted some of these divergences quite well. The ECB, for one, still sees inflation risk over the medium-term whereas the Fed is, of course, more concerned about deflation.

In line with the Fed's views, however, the ECB fears downside risks to growth. And finally, the major difference (which, still, may have longer-term impact on currencies) is that the ECB is still focused on tighter fiscal policy in the euro zone. In effect, the ECB feels it is essential for the euro zone to maintain the market's confidence in its budgets and this will be managed through rigorous budget austerity.

The U.S., meanwhile, with a much larger output gap than that of Europe (according to IMF data) has yet to address its burgeoning deficits and following the shift in the House will likely extend the Bush tax cuts, which would be a large drain on government revenues over the next 10 years.

Weekly trading recommendations

  • Enter long NZD/AUD at current levels with an initial object of 0.7991 and a stop of 0.7704.
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  • Enter long SEK/JPY at current levels with an initial objective of 12.9 and a stop of 12.214
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  • Enter long GBP/JPY position at current levels with an initial objective of 136 and a stop of 129.27.
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