QE2 has sunk the dollar

04/11/2010 by Philinje.

Now that the Fed has officially launched QE2, right on the heels of the midterm Republican wins, the market has reacted by selling the dollar and buying stocks, bonds and commodities. The reflation trade is back on.

Considering how widely opinion was converging on a correction in gold and silver, it seemed a near certainty that gold would drop to at least $1300. Right before the Fed announcement, there was a spike down to $1325, but that was as low as it got before recovering quickly and now heading back toward its recent all-time high around $1387 spot.

The dollar Index has broken 76 to the downside and therefore it looks like a double bottom around 76.5 may not occur. That could mean the dollar will quickly fall to 74, its low a year ago, and then if it keeps going, to its all-time low around 70. Probably it will break that level and head to the 50’s, eventually.

But there is reason to be cautious. The dollar is losing versus the Euro and pound but not other currencies and its recent decline already accounted for QE2 to an anticipated level of about $500 billion. The announcement was for $600 billion, so possibly most of the announcement is already baked into the price. The dollar index has moved slightly lower but it’s still in the territory of a long-term rising trend line.

We might see about a week of follow-through from the announcement, especially if there are no surprises in the NFP numbers this Friday. Probably most of the market is waiting for that final indicator to see if it really does make sense to short the dollar at this very oversold level, right on a rising trend line.

Playing the NFP will be especially tricky this time if there is a surprise. A really negative surprise could cause a risk-averse safe haven move into the dollar, even though in theory that would guarantee more low rates and reinforce that QE2 was justified.

But that’s the problem. Most of the announced QE2 is already in the dollar price. And what about a positive surprise? Well, then it could look like the Fed will raise rates sooner than anticipated and maybe even throttle back on QE2. Frankly, I think a positive surprise is more likely. The ADP figures this week were surprisingly positive and corporate earnings have been on the rise. If we get a big positive surprise, that could trigger a dollar rally.

In the meantime, here is a thought-provoking piece that contemplates one way China could defend itself against a falling dollar. Which makes sense. It’s another version of the new gold standard argument.

http://blogs.forbes.com/investor/2010/11/02/opium-wars-revisited-will-china-corner-the-gold-market/

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