Case for AUD strength hindered by FOMC

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By Chris Gore | February 21, 2013 11:42 AM EST

GoMarkets

'Strong Aussie' case hindered by FOMC

The Australian dollar took a hit overnight following the release of the Federal Reserve FOMC minutes which revealed some members advocate the scaling back of asset purchases. For many, highly accommodative policy in the United States (in the form of asset purchases such as quantitative easing) has been an essential part of 'Strong Aussie' equation, and the possibility of an early exit or gradual withdrawal of such asset purchases is now having an equal and opposite effect.

For those not familiar with the correlative value between stimulus and currency, we can define it as follows;

Since the Fed began to use "unconventional" measures of stimulus such as quantitative easing, the natural market reaction has been to sell the greenback. The more cash the Fed creates to facilitate such programs, the more the currency is diluted. Markets may respond in a variety of ways depending on the finer points of the program and expectations in the lead up; however the natural tendency is to sell the greenback and take on risk. Why? Because the Federal Reserve are artificially stimulating the economy. While the merits of such programs are clear, they also carry the risk of stoking inflation beyond desired or comfortable levels. These risks are deserving of another article entirely.

Back to the topic at hand, the Australian dollar falls into the category of 'risk' given its high yielding credentials, or comparatively higher interest rates. There are of course other important directives and attributes which define the Aussie's performance, but it's abundantly clear Fed's (inadvertent or otherwise) 'weak dollar policy' has made a significant contribution to the Aussie's out-performance in recent years. So if the Fed even consider taking the punch bowl away, high-beta (commodity correlated) currencies such as the Australian dollar and Kiwi are the first in-line to take a hit, which is precisely what we saw overnight.

Markets will are now attempt to define some sort of threshold before the Fed begins to unwind some US$85 billion in monthly asset purchases, for which the spotlight will be on the March 19-20 meeting to provide further clarity.

While we may not be able to categorise the minutes as the watershed moment to mark a sustained greenback reversal, it's abundantly clear the US dollar's innate aversion to stimulus has encouraged a sustained period of weakness, and the premise scaling down stimulus is its best hope of a meaningful reversal. For now, market participants will be watching top-tier releases in the context of Fed stimulus, any dramatic improvements (particularly surrounding employment) may encourage intermittent bouts of strength.

Extreme case scenarios...

Before we hit the sell button, it's important to remember markets have a tendency to factor in extreme-case scenarios. It is highly unlikely a mostly dovish Fed line-up will advocate a swift withdrawal of such an important life-line. Instead, the focus is likely to remain on the gentle withdrawal of stimulus should employment conditions in the U.S show further signs of recovery or fail to continue to display a willingness to scale back asset purchases all together.  With this in mind, we need to moderate the markets natural tendency to price in the extreme.

Domestically, the next key determinate for the Aussie dollar will be RBA Governor Glenn Steven's appearance before the House of Representatives Standing Committee tomorrow.

At the time of writing the Australian dollar is buying 102.45 US cents

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