Tuesday, 9 Aug 2011

How Will the Fed Respond to Yesterday's Stock Plunge?

The fallout from the US rating downgrade hit equities the hardest with the S&P 500 falling 6.6% and the pain has continued today with the German DAX down 5.9%. In contrast to yesterday the USD is lower versus the majors. With the Fed due to release its FOMC Statement today market players are speculating just how the Fed will respond to the market turmoil.

The ECB continued to buy Spanish and Italian bonds for the second consecutive day and has helped to stabilize European bond markets, albeit temporarily. Trichet was quoted by Reuters saying, “We are in the secondary market”. Yields for the Spanish 10-year bonds are trading below 5% while Italian 10-year yields are slightly above this level. Germany reported a smaller than expected trade surplus and a contraction in exports. Both data points hint at slower growth in Q2 for Germany.

UK manufacturing production was far from consensus forecasts with a contraction of -0.4% on expectations of 0.3% growth. The UK trade deficit was also noticeably weaker but the GBP has been resilient. A break above 1.6475 would likely take the GBP/USD to 1.6550. Today's low was halted at the 20-day moving average at 1.6267. A break below here could test 1.6230 near the 55-day moving average.

Later today the Fed will release a statement from its FOMC meeting. Given the turmoil in the market expectations are for the Fed to take action. Announcing QE3 today could cause a panic from market players and reduce confidence in the Fed's ability to control the economy. However, the Fed could change the wording in its statement to reflect its intention to hold interest rates at lows for a longer period of time. The Fed could also signal its intention to hold longer maturity assets on its balance sheet. All of these would be a USD negative. A failure by the Fed to act may also unnerve investors which could be positive for the dollar. Yesterday's low at 1.4130 is the initial support for the EUR/USD followed by Friday's low at 1.4050. The August high of 1.4450 is the first resistance.