HiFX's Dan Bell looks at when and how the US Fed might turn the tap off on its massive money printing stimulus programme

Here's our monthly currencies outlook and review with HiFX's senior dealer Dan Bell including a look at how the United States Federal Reserve may move to "dial back" its quantitative easing (QE), or money printing programme.

The Fed is buying US$45 billion in long-term Treasury bonds and US$40 billion of mortgage-backed securities monthly, as it strives to boost the economy by pushing down long-term interest rates to encourage borrowing, spending and hiring. But with US economic indicators improving, including a rebounding housing market and an improving job market, attention is turning to a possible end to QE.

Financial markets are therefore trying to pick how and when the US Fed may end QE. Bell notes that with its overnight bank lending rate at between zero and a quarter percentage point since December 2008 and the Fed now into its fifth year of QE, the markets have grown very comfortable with the Fed actions, helping sharemarkets surge higher and the US dollar weaken.

 The challenge for the Fed now is when and how to turn the tap off on its massive stimulus.

"Because if they come out and say 'we're just going to stop doing QE altogether,' we're probably going to have quite a negative reaction and that could create it's own issues down the track," says Bell.

"If you look back at history, every time the Fed has started to tighten monetary policy, there has actually been quite a negative financial event associated with that. So it's going to be a challenging process and (Fed Chairman Ben) Bernanke and a couple of his other voting members on the Fed have started talking about, or using language, to suggest that they might start dialling back the level of asset purchases over the next six to 12 months."

"They haven't put a timeframe on it but what they're saying is if the US economy continues to improve, maybe they can start to reduce the amount they're actually purchasing on a monthly basis. And at the moment they've kind of got this open ended policy so they've committed to buying US Treasuries, US government bonds and mortgage backed securities until they get unemployment down to 6.5% (it's currently 7.7%)," adds Bell.

"So if they do start to see these positive outcomes in US employment numbers, then I do think their sentiment and their comments might start to suggest that they'll reduce the amount that they're purchasing."

Nonetheless Bell suggests the Fed will want to keep the market second guessing.

"They don't want everyone to know exactly what they're going to do."

'Break down in risk on, risk off trade'

Meanwhile, Bell notes the correlation between the New Zealand dollar and the Standard & Poor's 500 stock market index, which was around 80% on a daily basis at the height of the global financial crisis when you could track the movement of the Kiwi-US cross rate with the S&P 500 index, has eased back.

"In the last quarter it has been as low as 34% on a daily basis and the previous quarter, from October to December 2012, it was running at about 55%," says Bell.

"So we're seeing a break down in that so-called risk-on, risk-off trade. Better data in the US is actually supporting US stocks and so supporting the US dollar. And I think that will continue over the next six to 12 months and follow through to my forecast which is that the New Zealand dollar will be under US80 cents by the end of the year and closer to US75c potentially."

The New Zealand dollar was at about US83.53c on Thursday afternoon.

A Cypriot warning

In the troubled euro-zone Bell says recent events with Cyprus, which is getting a controversial €10 billion bailout from the "troika" of the European Commission, European Central Bank and International Monetary Fund involving haircuts on some bank deposits, has unsettled the markets, even though Cyprus only represents 0.4% of European bank assets, and weakened the euro.

"The market has seen how the European policy makers have dealt with this situation and they've questioned whether they've got the ability to deal with a bigger issue and that could be in the form of Spain or Italy who continue to have their own problems and very, very sluggish economic growth. If this is the way they've dealt with Cyprus, how are they going to deal with a bigger economy?"

The Kiwi dollar was at about 65.50 euro cents on Thursday afternoon, not far off highs above 66 euro cents reached last year.

"We're also tracking pretty strongly against the pound, and obviously the UK economy has continued to face a very difficult economic environment and the pound is reflecting that."

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Dan Bell is the Senior Dealer at HiFX, a UK-headquartered foreign exchange dealer with significant operations in Australia and New Zealand. It has a dealing room in Auckland. See more detail here.