ESM Ruling, QE Drive FX

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The recent price action of the U.S. dollar tells us that investors are prepared for QE3 from the Federal Reserve. Knowing this, savvy traders will immediately wonder how much impact a third round of Quantitative Easing can really have if the market has already discounted the announcement. While it is true that most economists and investors expect the central bank to ease Thursday, we believe that the dollar could fall further if the Fed pulls the trigger on QE3. There're still some skeptics out there who are worried that the election could handcuff the Fed's hands or that the central bank simply doesn't have the guts to make such a big decision when data has been underwhelming but not abysmal. There is also a subset of investors who believe in QE3 but don't want to initiate any new positions until the announcement is actually made. Perhaps that's the smartest course of action considering that the size and scope of QE3 is still up in the air. U.S. dollar traders are positioned for QE3 but not necessarily for a specific size or span of time over which asset purchases will be conducted.

The benchmark against which QE3 will be measured is the last quantitative easing program, which was $600 billion in size and occurred over a seven-to-eight month period. When the Fed first announced QE2, this is what it said:

"The Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."

If the Fed were to announce QE3, there's no doubt that the asset purchase program would extend into January, which is beyond the election and fiscal-cliff hump. At that time, it will probably reassess and see if program needs to be expanded. The smaller the size and span of time that the commitment covers, the better it is for the dollar whereas open-ended QE, which is a low probability scenario would probably be very bearish for the greenback. If the Fed passes on QE and only makes changes to its rate guidance, the dollar would most likely soar as investors reverse their QE3 bets. Aside from quantitative easing, we are also looking for the central bank to alter the rate guidance language in the FOMC statement and extend its low-rates pledge from late 2014 to mid 2015. Once again, remember that the Fed will not only deliver its rate decision at 12:30pm ET (4:30 GMT), but also release its latest economic forecasts at 2:00pm ET (18:00 GMT) and hold a Bernanke press conference at 2:15pm ET.

EUR Soars On ESM Ruling And EU Banking Proposal
As we anticipated the German Constitutional Court did not stand in the way of Europe's rescue fund. It gave the green light to the ESM, removing a major hurdle that not only could have derailed the euro but also upset the stability in the region. The court's nod of approval came with conditions but they were not restrictive enough to kill the optimism in the market. The German Court now require Parliamentary approval for any liability in excess of EUR190 billion which is the share set out in the EU Treaty. More importantly, the German court's ruling green lights the ECB's bond purchase program. The European Union's Banking Proposal was also ambitious -- it gives the ECB supervisory authority across the European Union (let's see if the UK will agree to this!), gives the European Banking Authority the power to supersede national regulators, which means they can shut down banks and impose capital requirements if needed and asks for accelerated implementation of Prudential Regulations. The timing is also aggressive with a Single Supervisory Authority targeted for implementation by January of next year. It is important to remember that these proposals are subject to change. Establishing a common framework will not be easy because a number of countries in the European Union are concerned about giving up sovereignty over banking supervision.

Meanwhile the Federal Reserve is not the only central bank with a monetary policy announcement on Thursday. The Swiss National will be holding its quarterly monetary policy meeting and the main question for SNB is whether the EUR/CHF peg will be increased. The recent volatility in EUR/CHF reflects expectations for a higher peg and if the SNB fails to follow through we could see the pair slip back down toward 1.20. If the peg is lifted, EUR/CHF will immediately rise to the higher level and settle there for an extended period of time. We are also interested in hearing what the central bank has to say about the outlook for the economy through the release of fresh economic forecasts, which unfortunately could be downgraded.

GBP Lifted By UK Trade Data, Employment Next
The British pound traded higher against the U.S. dollar on the back of better than expected labor market numbers. According to the latest report, the number of people claiming unemployment benefits dropped by 15k in the month of August. The back-to-back improvement in July and August is good news for the U.K. economy and suggests that the country could be slowly pulling itself out of recession. Unfortunately we can't get overly excited because average weekly earnings growth slowed to 1.5 from 1.8%. The ILO unemployment rate, which is the three-month seasonally adjusted moving average of unemployment for workers aged 16 and greater also increased for the first time in seven months. Today's figures show some sign of improvement but much more progress needs to be made in the labor market before the Bank of England would consider dropping its easier monetary policy stance. There are no additional U.K. economic reports scheduled for release this week, which means the price action of the British pound will now depend on the outcome of the Federal Reserve monetary policy announcement on Thursday.

NZD RBNZ Leaves Interest Rates Unchanged
While the Australian and New Zealand dollars extended their gains against the greenback, the Canadian dollar weakened. Oil and gold prices held steady, which means that they cannot be blamed for the moves. The Reserve Bank of New Zealand left interest unchanged at 2.5% this afternoon. The decision wasn't a surprise especially considering that the RBNZ has kept interest rates unchanged since April 2011. According to Central Bank Governor Bollard the strong currency is undermining export earnings and government spending cuts is constraining demand. He doesn't expect strong growth but rather modest domestic activity in the coming years. This was in line with what the central bank head has been saying for the past few months. One of the main reasons why Bollard didn't say anything inspiring today is because he is stepping down at the end of the month. After five years as the head of New Zealand's central bank, he will be replaced by Graeme Wheeler on September 25. No economic data was released from Canada, which means today's move in the CAD is simply a correction after a long period of strength. Consumer confidence in Australia improved in the month of September according to Westpac thanks to low interest rates and positive job growth. While the data shows an improvement, the on the ground sentiment is still one of caution especially when it comes to the outlook for the Chinese economy. New Zealand Business PMI numbers are due for release later today followed by Canadian new house price index on Thursday. Like the British pound, the sustainability of the gains in the commodity currencies tomorrow will depend not on Canadian data, but on the Federal Reserve's QE3 decision.

JPY Will QE3 Prompt BoJ Intervention?
The Japanese Yen traded lower against all of the major currencies except for the Canadian dollar. Better-than-expected economic data out of Japan failed to lift the Yen. Machine orders rose 4.6% in the month of July, which was double market expectations and the corporate goods price index -- a measure of inflation -- grew by 0.3% in August. Part of the reason why good data fails to leave a mark on the Yen is because even the Japanese government doesn't believe that the economy is doing better. According to the Nikkei, one of the country's leading newspapers, the Bank of Japan is concerned about slowing exports and could cut its view on exports when it meets on September 19 and releases its economic report on September 20. Of course, the most important question that traders want answered is whether QE3 will prompt Bank of Japan intervention. This is a tough call not just for us, but also the BoJ. Whether or not the BoJ intervenes will depend on the magnitude of USD/JPY weakness. We have previously said that we believe 75.50 is the line in the sand for the BoJ and right now we are still trading 200 pips above that level.