Dollar Index at 4-month highs – does Euro weakness signal QE3?

Just to follow up on the Squawk Box call (Squawk Box_05.21.12), I’ve included a monthly Euro chart below, indicating the correlation of the currency’s weakness to Fed policy here in the U.S. As you can see, the last two extended periods where the Euro drifted into the $1.25-$1.30 range resulted in Fed policy action here in the U.S. Many economists have noted that the Fed’s first two asset purchase programs (QE 1 and 2) were largely employed in an effort to weaken a strengthening dollar (vs. the Euro and other currencies) to boost exports and subsequently stimulate the domestic economy.

We’re clearly approaching comparable levels once again with the Dollar index at 4-month highs, and the Euro trading below $1.30 for the better part of May thus far. With Japan announcing its additional easing programs earlier this month, and the Chinese government signaling over the weekend its willingness to add more aggressive monetary and/or fiscal  policy (likely to combat a recently appreciating yuan), many investors are now looking at the Fed to come in with its next initiative when its current program (Operation Twist) end in June.

The Fed has been particularly coy about the prospect of additional QE, although Bernanke himself has never taken the idea off the table. In addition to the currency conditions described above, the Fed also has a bit of a buffer zone now with equities and commodities weak over the last month or so. An announcement of additional QE (or something like it) at its next meeting in June would likely send the struggling commodities/metals markets surging off its recent lows, give equities another shot of adrenaline, and bring the dollar index back below the 80 handle (perhaps also helping avoid a Euro collapse).

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