The Federal Reserve has continued to lay the groundwork for unwinding their emergency programs, driving the U.S. dollar higher against all of the major currencies. Not only was the tone of the last FOMC statement of the year more upbeat, but it included a brand new paragraph detailing their plans to shut down a large portion of the alphabet soup of liquidity facilities in early 2010. Although there was quite a bit of volatility in the forex market immediately after the FOMC announcement, traders quickly realized that even though the Fed left interest rates unchanged and reiterated that interest rates will remain exceptionally for an extended period, they are inching closer to tightening monetary policy. Their upgraded assessment of the labor market, income growth, household spending and financial market conditions reinforced the dollar bullish sentiment that has been seeping into the markets. By acknowledging the improvements in the economy and in turn downplaying the risks, the Federal Reserve has given dollar bulls the green light to charge forward. We believe that the recovery in the dollar should last for the remainder of the year.
Going into the FOMC announcement, the market was looking for a more upbeat tone from the Fed, additional plans to unwind emergency measures and a discount rate hike. Two out three was enough satisfy dollar bulls and helps to explain why the greenback reacted positively to the statement. As usual, the devil is in the details. The central bank believes that the deterioration in the labor market is abating and that companies have shifted from laying off staff to becoming simply reluctant to hire. They also said that income growth is modest, which is an improvement from their previous assessment that income growth was sluggish. Last month, the Fed only said that the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010. This month, they have expanded this statement to include the expiration dates of special liquidity facilities, temporary swap agreements and asset backed securities. Given the extremely low possibility of a discount rate hike, which would have come at odds with their intention of keeping interest rates low and plans to taper off asset purchases, this is the best possible outcome that dollar bulls could have hoped for. Over the past 3 decades, the U.S. central bank has never raised interest rates before the unemployment rate peaked. If the unemployment rate peaked last month, then the Fed is on track to raise interest rates in the second half of 2010.
We highlighted the changes in the FOMC statement below (with some comments on the language). We also crossed out any sentences that were omitted from the previous statement in the current statement. Hope you find this useful!
Comparing the FOMC Statements
FOMC Statement December 16, 2009
For immediate release
Despite a heavy dose of U.S. economic reports this morning, the lack surprises left the control of the market in the hands of dollar bulls. The greenback held onto its gains ahead of this afternoon's Federal Reserve monetary policy announcement on the expectation that the Fed will be more upbeat and announce plans to shut down additional emergency programs.
Yesterday we learned that producer prices increased significantly in November but the strong price pressures on the wholesale level failed to translate into strong price pressures on the consumer level. This was partially due to discounting by apparel and electronic retailers as well as the fact that gasoline prices gradually declined last month even though oil prices held steady. Producers are having a tough time passing higher costs to consumers because demand is weak. On a headline basis, CPI rose 0.4 percent but if we exclude food and energy prices, consumer prices were unchanged last month, leaving the annualized CPI rate at 1.8 percent and 1.7 percent ex food and energy. Meanwhile the current account deficit widened in the third quarter from -$98B to -$108B, reminding everyone that the twin deficits are here to stay. The one area of continued strength is housing. Despite a drop in builder confidence, housing starts increased 8.9 percent while building permits rose 6.0 percent to the highest level in 12 months.
Counting Down to FOMC
For more on the FOMC Rate decision, read our FOMC Preview
We expect the dollar to remain firm ahead of the FOMC announcement. Based upon the price action in the forex, equity and bond markets, traders across different asset classes are all positioning for a hawkish outcome from the Fed. The 3 things that investors will be looking for will be the tone of the FOMC statement, changes to the discount rate and any plans to end emergency programs. The sharp moderation in job losses and improvement in consumer spending will encourage the Federal Reserve to grow more comfortable with the outlook for the U.S. economy. However there are still plenty of reasons why the Fed may not want to appear overly hawkish and therefore quite a bit of uncertainty rests with tomorrow’s FOMC statement. We only expect the bare minimum from the Fed because they realize that at this critical juncture in the U.S. recovery, there are more consequences than benefits to being overly hawkish. Although we believe that the Fed will underwhelm, dollar bulls may not need much to be satisfied and therefore any subtle changes to the language of the FOMC statement could affect how the dollar trades. A more upbeat tone by the Fed would be positive for the dollar while skepticism about the sustainability of the improvements in the labor market or consumer spending could reverse the greenback’s recent gains. The tone of FOMC decision should determine how the dollar trades for the remainder of the year.
How the U.S. dollar trades for the remainder of the year will be largely dependent upon the outcome of Wednesday’s Federal Reserve monetary policy announcement. Over the past 2 weeks, the dollar has strengthened significantly and the central bank’s degree of hawkishness will determine whether the dollar will break its 3 month high against the euro. The sharp moderation in job losses and improvement in consumer spending will cause the Federal Reserve to grow more comfortable with the outlook for the U.S. economy. However there are still plenty of reasons why the Fed may not want to appear overly hawkish and therefore quite a bit of uncertainty rests with tomorrow’s FOMC statement. Although we believe that the Fed will underwhelm, dollar bulls may not need much to be satisfied and therefore any subtle changes to the language of the FOMC statement could affect how the dollar trades. A more upbeat tone by the Fed would be positive for the dollar while skepticism about the sustainability of the improvements in the labor market or consumer spending could reverse the greenback’s recent gains.
The 3 things that investors will be looking for tomorrow will be the tone of the FOMC statement, changes to the discount rate and any plans to end emergency programs. We only expect the bare minimum from the Fed because they realize that at this critical juncture in the U.S. recovery, there are more consequences than benefits to being overly hawkish. Now let’s take a look at these 3 questions in further detail:
1) What will be the Tone of the FOMC Statement?
The Federal Reserve provided very little optimism and very little action when they met on November 4th. At that time, the central bank was weary of a jobless recovery and losses in the commercial real estate sector. They were also mindful of the risks associated with a weak dollar and low interest rates. Since that meeting, the U.S. economy has improved. According to the table at the end of this article, the labor market has taken a turn for the better along with consumer spending and confidence. Inflationary pressures also accelerated, while asset prices increased. However the latest non-manufacturing ISM report indicated that activity contracted last month. Given that the service sector represents more than 70 percent of the U.S. economy, the slowdown is certainly worrisome. The manufacturing sector, which previously led the recovery, is also slowing. Furthermore, less than 36 hours after the non-farm payrolls report was released, Fed Chairman Ben Bernanke gave a speech warning about the risks facing the economy which suggests he is not convinced the improvements are here to stay. Therefore we expect a slightly more hawkish but still very cautious tone from the Fed which should help the dollar extend its gains. However the reaction in the dollar should be tempered by the strong likelihood of the Fed repeating the well worn statement that interest rates will remain “at exceptionally low levels” for an “extend period.”
2) Will the Fed Raise the Discount Rate?
Spurred by an article today’s Financial Times about the upcoming FOMC rate decision, there is now speculation that the central bank could raise the discount rate. In our view this is extremely unlikely because we expect the Fed to first announce plans to unwind some of their emergency measures before taking this relatively bold move. Raising the discount rate, which is the rate that regional Federal Reserve banks lend to commercial banks would carry with it hawkish monetary policy connotations. It also would be at odds with the Fed’s commitment to keep interest rates low and plans to taper off asset purchases. However the fact that the Financial Times has raised this option reflects the growing division within the FOMC. Certain Fed officials are more hawkish than others and we expect the division on monetary policy to increase as the economy continues to improve.
3) Will the Fed Announce Plans to Unwind Emergency Measures?
Given the Federal Reserve’s commitment to slow their pace of asset purchases over the next few months and to complete their program by the end of the first quarter, we expect the central bank to step up their plans to unwind emergency measures. There is a good chance that they will also end other emergency programs and any specifics on this front should also be positive for the U.S. dollar.
What to Expect for the EUR/USD
Although 1.45 is a significant support psychological support level for the EUR/USD, 1.44 is the true technical support as it represents the former breakout point in the EUR/USD back in September. If the Federal Reserve is hawkish enough to satisfy dollar bulls, expect this level to be tested. However if they fall short of market expectations and remains cautious, the EUR/USD could rebound back above the 100-day SMA at 1.4650.
As we countdown to the Federal Reserve's monetary policy meeting, conflicting inflation, Treasury international capital flow (TIC) and manufacturing numbers will make the Fed's decision on Wednesday particularly difficult. Granted the U.S. central bank is not expected to alter interest rates or the size of their Quantitative Easing program, their degree of hawkishness or dovishness could set the tone in the dollar for the reminder of the year. Producer prices which measures wholesale level inflation increased 1.8 percent in November with core prices rising 0.5 percent. On an annualized basis, PPI rose by the strongest pace since October 2008. Unsurprisingly, the weakness of the U.S. dollar, rise in gasoline and other energy prices played a big role in pushing PPI higher but aside from a drop in the price of passenger cars and computers, stronger price pressures was seen everywhere. However unlike oil prices, gas prices fell gradually last month which means that even though we also expect consumer prices to rise, the pace of growth may not be as strong as PPI.
Conflicting Manufacturing Activity
Stronger inflationary pressures, a pickup in consumer spending and a dramatic improvement in the labor market should encourage the Fed to adopt a more hawkish tone on Wednesday. Unfortunately the sharp drop in the Empire State Manufacturing survey will make it difficult for the Fed to be anything more than cautiously optimistic. The index fell from 23.51 to a five month low of 2.55 which indicates that manufacturing activity slowed significantly last month. The only saving grace is the rise in industrial production in November and the increase in capacity utilization which suggests that the slowdown in the NY region may be unique to the Empire State.
Foreign Demand for Dollars Decline
The dollar did weaken slightly following the Treasury International Capital flow report which indicated that foreign investors were net sellers of dollar denominated assets in the month of October. Even though demand for long term U.S. Treasuries increased, demand for short term liabilities declined, creating a net outflow of $13.9B. Brazil, HK, Ireland and France were the biggest buyers of U.S. dollars while the U.K., Luxembourg and Japan were the biggest sellers. Chinese demand was flat in October. The trend of investors are shifting from short to long term investments represents their greater confidence in the U.S. recovery.
Significance of Turn in Dollar Positioning
The EUR/USD has fallen significantly over the past 12 hours on the speculation that Austrian Banks may be the next to crumble. We think it is worthwhile to revisit a point that we made in our daily report last evening which suggested that the turn in dollar positioning last week foreshadowed a deeper decline in the euro and stronger rally in the U.S. dollar.
On Friday, the CFTC released their weekly Commitment of Traders Report, which measures positioning in the commodity markets. According to data from the Chicago Mercantile Exchange, future traders have reduced their short dollar positions across the board. In fact, speculative positioning in the EUR/USD turned net short for the first time since May. This shift from net short to net long dollars against euros is extremely significant. Since 2005, there has only been approximately 4 times (not including this time) that EUR/USD positioning has flipped to net short after being net long by more than 20k contracts. Each time, this shift in dollar positioning was a precursor to a more significant rally in the U.S. dollar. According to the following chart, the last time that speculative EUR/USD positioning (white line) flipped from net long to net short was in the first week of August 2008 and interestingly enough, that was the very week that the breakdown in the EUR/USD began, with the currency falling more than 3,000 pips or 20 percent over the next 3 months. W are certainly not saying that the EUR/USD will fall 20 percent from current levels because the move in the EUR/USD following each shift in dollar positioning has varied in terms of magnitude. However, the yellow vertical lines on the chart show that a flip consistently foreshadows a sell-off in the EUR/USD. If the Fed grows more hawkish on Wednesday, we could have a fundamental trigger for a more meaningful decline in the EUR/USD.
