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FX Trading – Risk sentiment: up and down and up and down …

A little Love Rollercoaster to start your day …

Move it over dad ‘cause I’m a double-dipper
Upside down on the zip-zip-zipper

Sorry – couldn’t resistance. Looking at the US economic data released this morning and the early impact of QE2 and the recent calls for a double dip in housing, why not try to lighten spirits a bit?

Or we could adapt the song, modernize it a bit, and convey the undeniably gloomy outlook …

Move it out your house ‘cause it’s a double-dipping
Upside down and its slip-slip-slipping

The stated intent of QE2 is to alleviate unemployment and stabilize the US economy. Wrapped up in there is the hopeful enticement to refinance when rates fall even further or at least hold steady at already low levels. Well, it’s been two weeks and rates have actually risen, not fallen. Bond yields and mortgage rates are both higher.

10-Year Note Yields:

30-Year Fixed:

And this has much to do with mortgage applications, reported this morning, falling 5% — their sharpest fall this year. Refinancing plunged by nearly 17%. It may be early still but it looks as though the Federal Reserve is already failing with QE2. If this trend is sustained, there will be plenty of people saying “we told you so.” In this environment of deleveraging and saving (a household balance sheet recession), calling it easy money does not make anything easy.

If expectations don’t change, the sweat may really start pouring from Ben Bernanke’s bald head. A. Gary Shilling believes housing prices in the US will fall another 20%. Other estimates are for declines ranging from 4% to 15%. That’s a deflationary force the Fed will not be able to counter as it further seeps into consumers’ already strained financial situation. Not a pretty picture when the Fed is trying to induce inflation.

But of course the debate will continue as to whether QE2 is necessary or effective or well-conceived or detrimental. This week we learned that economists (e.g. John Taylor of Taylor Rule fame and Jim Chanos) and conservative-leaning politicians are lobbying for a reconsideration of QE2. In response, several Federal Reserve board members and regional bank heads are out defending the need for additional easing measures.

The question, which can only be answered by the market process, will be whether consumers (and perhaps businesses too) are more inclined to borrow this time around than last time QE was implemented. If they are not, and we get a relapse of the housing and growth fears that scared everyone two years ago, then things could get ugly.

Going back to the Dollar Smile, which was defined in a recent report we sent, there are three scenarios that drive the US dollar over the long term. We’ve talked about how a growth surprise in the US, especially relative to the Eurozone, could be supportive of the buck. We talked about how the US currently muddling, without relapsing into recession, along would be supportive of global growth but would not be supportive of the US dollar.

What we’ve talked about today shows that the third scenario, where the US dollar is supported by a risk bid (left side of the smile), is still very much in play. Managing consensus expectations for one major problem is doable. But if investors start connecting the dots again, bringing all the major problems to a head at the same time, then risk-averse money flow can certainly dominate.

It’s like déjà vu all over again.