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What the End of QE2 Will Do to the Dollar

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Yes, the Greek drama is fascinating. But don't forget - QE2 is ending, and that will hit currencies too. Here's how.

The dollar has been chopping around lately, largely on the news from Europe. But back home, the looming end of QE2 is likely to have an effect as well. And traders who are short dollars could get a nasty surprise.

How nasty? We don't exactly know, says Paresh Upadhyaya, head of Americas G10 strategy at Bank of America Merrill Lynch. The question of "Are we in for a more material slowdown in growth and the fiscal question" and the debt ceiling debate at the same time "is unusual," he told me. "It's not open and shut.

"In the end, we may remain range bound, but don't be overly complacent," if you are short dollars, Upadhyaya says. He points to one indication of what might happen: in the first quarter or so after QE1, the euro and the yen both moved down about 6% while the dollar rose roughly 2%.

Part of the problem now is that investors who are pessimistic about the U.S. economic outlook have been trading accordingly. "The recent sharp move lower in Treasury yields suggests some market participants may have been expecting QE3," Upadhyaya says. Fed funds futures contracts tell a similar story: Upadhyaya found that investors are now pricing in a rate hike in August 2012, much later than three months ago, when they were expecting it in January 2012.

In Upadhyaya's view, though, another round of quantitative easing is highly unlikely, since it would be politically difficult, potentially less effective, and quite possibly not necessary. If there is not, in fact, a QE3, he says, "There is a not-so-insignificant possibility of an unwind of those expectations that could send interest-rate differentials moving in favor of the USD in the near term, in our view."

True, some of the more extreme short-dollar positions have been unwound in recent weeks. But investors still have significant shorts on the dollar against several currencies, Upadhyaya says. He mentions the euro, the Australian dollar, the Swiss franc, and to a lesser extent, the Canadian dollar. And then there's the yen.

"That's where the really big risk is," Upadhyaya told me. "That's where complacency could come and bite currency investors."

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