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Analysts: FX Mkt Debates 'Operation Twist,' QE3 Effect On Dlr

By Vicki Schmelzer

NEW YORK (MNI) - If the Federal Reserve opts Wednesday to implement an "Operation Twist" type of measure that leaves the balance sheet largely unchanged, the dollar may see little or no reaction, analysts said.

However, if the balance sheet increases more markedly or if the central bank decides that QE3 is needed, the greenback would likely suffer, they said.

"The market expectation is solidly that some form of 'operation twist' will be put in place - replacing short-term assets with longer-term assets in the Fed's portfolio," said Steve Englander, head of G-10 strategy at CitiFX.

"It is less clear whether the Fed will simply reinvest the maturing assets or actively sell short-term assets in addition to reinvesting matured assets," he said.

CitiFX economists favor the latter scenario, "and it makes sense that the Fed would have a target in mind rather than have twisting passively determined by the rate at which assets mature," Englander said.

As for currency effect, an announcement of QE3 would be deemed dollar negative, and Englander stressed that global investors "are primed to sell dollars on any QE-type balance sheet expansion."

However, if the Fed offers $500 billion (as Citi economists envision) "of twisting and no QE3 plays out," FX direction will be less clear, he said.

Recent conversations with FX investors suggest "that there will be tail disappointment on the outcome and that might outweigh the impact of the marginally more aggressive active rather than passive terming out," Englander said.

"For FX investors, we would view that combination as small risk-off," he said.

From an FX standpoint, much will depend on whether the Fed takes an "active" or "passive" approach to "Twist," said Marc Chandler, global head of currency strategist at Brown Brothers Harriman.

A "passive" stance would be if the Fed does about $250 billion ("roughly the mortgage-backed securities that mature (paid off/come due etc.) in the next twelve months)," he explained.

If the Fed takes a more "active" approach, they would be likely to "focus on what they have a lot of," which would be two and four-year instruments, Chandler said.

Also to be factored in is the FX response if the Fed decides to lower the interest rate paid on excess reserves held by banks, he said.

"The less the Fed does, the better the dollar reaction," Chandler said.

A more "active" stance may be construed as bearish for the greenback, and the more "active" the Fed's actions, the greater negative impact on the dollar, he said.

"Passive is less than active, active is less than active plus a cut on excess reserves, which is less than QE3," Chandler said.

Keeping the Fed's balance sheet unchanged may do little for the dollar, or at best underpin the greenback slightly, analysts said.

"The Fed's twist operation will be dollar positive as long as it constitutes no increase in the Fed's balance sheet," said Ashraf Laidi, CEO of Intermarket Strategy.

He reminded that upward cycles in the euro have, in the past five years, largely been driven by Fed easing and "relative ECB hawkishness."

A move towards a "Twist" will likely be 'inadequately dovish' to weigh on the dollar," Laidi said.

Despite all the talk of "Operation Twist," there is still the fear that the Fed might jump directly to QE3, which like QE1 and QE2, would likely weigh on the dollar, albeit potentially to a lesser degree.

"In the current environment of already very low implied real yields and renewed tension in the global banking system, we think it will be difficult for the Fed to generate a meaningful acceleration in broad dollar-based credit growth," said Jens Nordvig and Charles St-Arnaud, FX strategists at Nomura, in a research note.

"If the transmission from Fed balance sheet expansion to international credit and portfolio flows is hampered, the impact on the dollar is also in question," they said.

Under this scenario, QE3 may not necessarily be the trigger of a new wave of dollar selling, the strategists said.

"A moderate balance sheet expansion is unlikely to be a strong catalyst for dollar weakness at this point," Nordvig and St-Arnaud said.

"In short, the basic lessons from QE1 and QE2 may not be directly applicable to QE3," they said.




Ashraf