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Wednesday, 29 February 2012 06:02

Fed's Semiannual Economic Update

On Wednesday at 1000ET/1500GMT, Fed Chair Bernanke will present the Fed's semi-annual economic update to the House Financial Services Committee. Headlines from his prepared remarks will flash across at the start of his testimony, and Q&A later will provide for more headlines.

In his prepared remarks, we think Bernanke will strike a cautiously optimistic tone in light of recent stronger US economic data reports. But we also think he will highlight ongoing headwinds to the US recovery (primarily from potential fallout from the Eurozone debt crisis, still too-high unemployment, and a cratered US housing market, higher gasoline prices to boot ), keeping the overall slant of his outlook on the dovish side. We think Bernanke will make some mention that the Fed is still considering whether to provide additional stimulus to the recovery (keeping options open), but that he won't make any explicit commitments that fresh stimulus is on the way. The risk here, in our view, is that Bernanke does signal that the Fed is closer to a third round of asset purchases (QE3), potentially sharply undermining the USD (especially USD/JPY) and stoking further gains in risk assets, like stocks, commodities, and commodity FX (AUD, CAD, and NZD).

On balance, we think Bernanke's likely cautiously optimistic and yet dovish outlook should be supportive of risk sentiment overall, and thus tend to bias the greenback to further weakness. However, markets will still be digesting the results of the ECB's LTRO from earlier in the European morning (as well as the Feb. Chicago PMI 15 minutes before Bernanke), possibly making Wednesday a 'one-two' type of trading day.

If the LTRO is positive for risk appetite and risk assets have already rallied into Bernanke's testimony, we would be on guard for a potential risk reversal lower on profit-taking, especially if Bernanke highlights the vulnerabilities of the US recovery and the risks for setbacks. Alternatively, if Bernanke downplays the need for additional stimulus based on an improved outlook, markets may also resort to profit-taking, as QE3 is less likely. Only if he provides more specific indications that QE3 seems more likely would we then expect risk to rally further.

If the LTRO leaves markets wanting, and risk sentiment deteriorates or succumbs to profit-taking after the fact, Bernanke's testimony may actually provide the opposite effect to the scenario outlined above, potentially leading to revived risk appetite if the Fed Chair expresses greater optimism, or the determination to act if the recovery falters.

In terms of price levels to watch, key short-term EUR/USD support comes in at 1.3330/50 area, while strength above 1.3475/85 highs may see gains extend toward 1.3570/80. In USD/JPY, we look at the 79.70/80.00 as important short-term support, while strength back above 81.00 may see new highs toward 82.00. Overall, our preference is to use pullbacks in USD/JPY and JPY-crosses as opportunities to enter longs, potentially in the 78.50/79.00 area in USD/JPY and 84.00/50 in AUD/JPY. We would abandon that strategy if Bernanke gives strong signals that QE3 is more likely than not.
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