How QE3 and the Fiscal Cliff Really Hit the Dollar

Fiscal Cliff Rescue
Colin Anderson | Photographer's Choice | Getty Images
Fiscal Cliff Rescue

QE3 will have less impact than experts expect, this strategist says, and investors who are short the dollar will get a surprise.

Markets went a little crazy after the Federal Reserve announced its latest round of quantitative easing. Did they go overboard?

David Woo, head of global rates and currency research at Bank of America Merrill Lynch , is more tactful than that. But in a new analysis, Woo breaks down the potential long-term impact of QE3 and finds that there is a lot less than meets the eye.

"The fact that downside for real yields is limited means the impact of more QE on asset prices will likely be also limited," he wrote in a note to clients. In other words, with inflation-adjusted interest rates so low, a kay goal of QE3 - to push yields lower and induce investors to move into riskier assets like stocks and real estate - will be harder to meet. Or as Woo puts it, "this reinforces our general view that QE is at risk of becoming increasingly ineffective."

That's hardly good news for the economy - and it's not so great for some currency investors either, Woo says.

"The short USD positions and long risky assets positions that investors have been building up over the past two months may be vulnerable, especially if some of the key risks we see facing the markets were to materialize in the weeks/months ahead."

Speaking of risks ahead, Woo is paying increasing attention to the prospect of the fiscal cliffand the ensuing U.S. fiscal tightening. That eventuality could be good news for the dollar on three fronts, he says: it would boost the odds of a hard landing in China and a recession in Europe, tightening would increase confidence in the dollar as a reserve currency, and it could lead to higher yields if investors start worrying about deflation.

To trade on the dollar's prospects, Woo recommends buying the greenback against the Canadian dollar. He wants to enter the trade right around 0.9800 with a stop at 0.9600 and a target of 1.0200.

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