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FOMC, ECB and the Independence Vote

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Today marks the beginning of a potentially volatile trading period for the Pound, Euro and US Dollar due to three major news events. The FOMC is the first to affect markets, with the FOMC statement to be released at 21:00 server time today; this will be followed by a press conference at 21:30 server time where Janet Yellen will expand upon the FOMC statement and then take questions regarding monetary policy.

Analysts have been focusing heavily on the wording of interest rate rises as the potential market mover:

“The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

There is some speculation that with Quantitative Easing considered on autopilot to end in October, the Fed will change this sentence to reflect that rates could start rising by mid-2015. With economists generally accepting that the FOMC will reduce asset purchases by a further 10 Billion at this meeting, there is also potential for them to outline how the final 15 Billion will be reduced. Current expectations are that this final amount concludes in October and the purchases will be concluded at next month’s meeting. With tapering largely priced in, most of the action in currency markets is likely to surround the wording of interest rate rises above, as well as any indication on next month’s tapering and the concurrent economic forecasts.

The European Central Bank is the next in line to move currency markets; the ECB will announce the allotment of its first Targeted Long Term Refinancing Operation on Thursday. The ECB released the following updated modalities in July regarding the timing of the programs – the allotment at 11:15am Frankfurt time is likely to be the market mover:

Since zero interest rate policy was reached during the GFC, traders have had one eye on central bank balance sheet expansion as an indicator of easing; T-LTRO’s being one way in which the ECB can expand its balance sheet. Traders will be looking at the size of the allotment relative to expectations as a guide to which way the Euro will move. While it is never clear exactly how the market will react, a strong uptake could lead to Euro weakness as traders see the ECB expanding its balance sheet by a larger amount, while similarly a weak uptake could see a short squeeze as implied easing is not confirmed and positions unwind. Since the previous LTRO programs, banks have been repaying their loans prematurely which has put downwards pressure on the ECB’s balance sheet; the ECB is seeking to buck this trend and return the balance sheet to 2012 levels.

There are some factors that will influence the uptake of the program that are worth considering. Firstly, while the program is intended to stimulate new lending to the private sector there is no clear penalty in place for misdirection of the funds away from lending apart from early repayment of the funds – this may lead to demand for other purposes. The ECB states:

“Counterparties that have borrowed in the TLTROs but whose eligible net lending in the period from 1 May 2014 to 30 April 2016 is below the benchmark will be required to pay back their borrowing in September 2016, in accordance with the ECB Decision.”

However with yields far lower now than at the time of the previous LTRO’s it is not clear that the risk/return profile is still favourable for this sort demand.

Secondly, the ECB’s latest rate cut brings the cost of funding through the program down to 15 basis points, which should help to spur demand for the funding and may have been a factor in the ECB’s decision to surprise markets at the previous meeting.

Thirdly, while not directly related to the current uptake of the program it should be noted that the current LTRO’s occur around the same time as the previous LTRO’s from 2011 and 2012 are maturing. These programs mature in January and February 2015 and will partly offset the balance sheet increase due to the new round of T-LTRO’s as banks repay previous loans.

During the ECB allotment – but to be announced afterwards – Scottish citizens will be voting in a referendum as to whether Scotland should be independent from the United Kingdom. A ‘Yes’ vote will mean Scotland separates from the union, while a ‘No’ vote will result in the country staying a part of the UK.

Votes are strongly divided according to the most recent polling by YouGov, with 52% of those surveyed indicating a No vote and 48% indicating a Yes vote on a head to head basis. On current indications this means that there would be no separation between the countries. One thing to keep in mind is that these polls exclude those who don’t know or wouldn’t vote, and these citizens may not feel strongly enough about the separation to take the plunge and vote Yes.

That said, Scotland would be likely to control the majority of oil revenues coming out of the current United Kingdom, with some analysts indicating that Scotland would receive up to 90% of oil revenues – a great boon for the economy and one reason for a strong showing on a Yes vote.

A Yes vote is likely to have an effect that reaches farther out than the UK economy. The Pound has potential to drop or rise very strongly depending on the outcome; the effect will depend upon both the positioning of traders ahead of the release and outcome.

The Pound is not the only currency that could move sharply on an announcement; the sentiment in Europe for parting from various unions such as Catalonia from Spain and Greece from the Euro would be heavily influenced by Scotland setting a precedent. Traders should be on the lookout for knock-on effects of the vote on currencies such as the Euro during this time. Historic events such as this can have dramatic outcomes, and the effect on markets can present both opportunity and risk.

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