Ask any expert on the economy or the foreign exchange market and they will tell you that Quantitative Easing is bearish for the U.S. dollar because the Fed prints money to fund their bond purchases. However, aside from the dollar’s decline the day of the FOMC announcement, we haven’t seen much weakness in greenback. In fact, over the past 48 hours, the dollar rebounded against all of the major currencies (the GBP being the exception), which interestingly enough is exactly how it traded after QE1 and QE2. On the day that the Fed announced a third round of Quantitative Easing, we released a few charts showing how EUR/USD and USD/JPY reacted in the days and weeks that followed. In both cases, the dollar weakened the day the Fed eased but after QE1, the dollar rallied against the EUR for 4 days before collapsing hard. During this time, USD/JPY consolidated and then joined the sell-off when the EUR/USD started to move higher. QE2 on the other hand marked a bottom in the greenback against the euro and Japanese Yen. The main reason why Quantitative Easing is not always bad for the dollar is because often times investors are relieved to receive more support from the central bank. This time however, the lack of continuation in equities suggests that the rebound in greenback is driven more by a buy the rumor and sell the news mentality in the EUR/USD. Investors have been pricing in the possibility of QE3 for weeks and the reaction that we are seeing right now is indicative of profit taking. We are still looking for the dollar to resume its slide but it could rally another 1% before that happens.

Better than expected U.S. economic data also lent support to the greenback. The nation’s current account deficit narrowed to -$117.4B in the second quarter from a downwardly revised -$133.6B. Stronger exports and a larger income surplus helped to return the deficit back to Q4 levels. Unfortunately this improvement is not expected to last, as the recent slowdown in Chinese growth is likely to restrain export demand in the third quarter. Demand for dollar denominated assets has also been very strong according to the Treasury International Capital Flow report, which saw net inflows rise by $73.7B in July, up from $15.1B the previous month. Purchases of long term Treasuries accounted for most of the increase. This is consistent with the sharp rally that we saw in the U.S. dollar against the euro that month. If you recall, the EUR/USD dropped to its 2 year low of 1.2042 in July. While demand for U.S. Treasury bonds was strong, foreign investors sold a large amount of shorter-term Treasury bills.

FOMC Voters Dudley and Lacker are scheduled to speak later this afternoon on the economy and monetary policy. We will be listening carefully to see if these central bank presidents agreed with the move made by the Fed last week and whether the ultra dovish monetary policy stance is warranted. If their views are consistent with the Fed’s recent actions and forward guidance, the dollar could resume its slide but if Dudley or Lacker, question the need for last week’s aggressive move, we could see more profit taking on short dollar positions.

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