US Dollar Risks And The Four Fed Surprises

The Federal Reserve holds its last policy meeting of 2013 in the week ahead. In UBS’ view there are four possible surprises that could affect the markets. From the odds of a taper to adjusting forecasts and from forward-guidance communication to the chances of a cut in the IOER, the FOMC meeting in the week ahead presents upside and downside risks to the dollar in the near term; even if UBS believes the longer-term will see USD strength against both the EUR and JPY.

Via Syed Mansoor Mohi-uddin of UBS,

First, the Federal Open Market Committee may decide to start tapering its $85bn a month of asset purchases. UBS Economics expects policymakers will wait until the January 28-29 FOMC meeting as inflation remains well below the Fed’s 2% target. Until recently the strong consensus view was for the Fed to wait until its March 18-19 meeting. But the prospects for policymakers to move earlier are rising.

At the September 17-18 FOMC meeting officials refrained from tapering, citing weakening economic data, upcoming fiscal risks as the government prepared to shut down in October, and tightening financial conditions. Three months later those hurdles are substantially lower.

US data continues to firm. Payrolls have increased by 204k jobs on average per month over the last four months. November ISM printed at 57.3 its highest level since the spring of 2011. November’s retail sales increased by 0.7%m/m. In addition, September and October’s retail sales were revised higher to 0.1%m/m and 0.6%m/m respectively.

Furthermore, the risk of another government shutdown has receded. Last week the House of Representatives voted for the budget deal agreed between Republican Ryan and Democrat Murray. This is the first bipartisan budget to pass the House in four years. It will only marginally reduce planned spending cuts, and still needs to be passed by the Senate. But more significantly it markedly improves the outlook by reducing fiscal uncertainty for the next two years.

Financial market conditions also appear more benign in the run up to this month’s FOMC meeting. In particular ten year bond yields remain below 3.00%. In contrast, before September’s FOMC meeting, Treasury rates had almost doubled from 1.60% in May to 3.00% in September.

Before the Fed’s latest ‘black-out’ period began, three FOMC members spoke. Richmond Fed President Lacker said he expected tapering to be discussed at this month’s meeting. Dallas Fed President Fisher said the central bank should begin cutting its bond buying at the ‘earliest opportunity’. Both hawks are non-voting members of the FOMC this year, though Fisher will get to vote during 2014. In contrast, St Louis Fed President Bullard, a voting FOMC member in 2013, said tapering should remain depend nt on upcoming data especially as inflation remains well below the Fed’s 2% target. But Bullard also said ‘a small taper might recognize labour market improvement while still providing the [FOMC] the opportunity to carefully monitor inflation during the first half of 2014.’

If the Fed does announce in the week ahead that it will start tapering its asset purchases – and makes no other policy changes – we expect the dollar will benefit. The FOMC holds eight meetings a year. If tapering is agreed this month, the Fed could potentially finish printing money well before the end of 2014. In his November 20 speech to the Economists Club in Washington DC, Chairman Bernanke made it clear policymakers are more comfortable exercising control over the Fed funds target interest rate than through ‘Large-Scale Asset Purchases’.

Second, the FOMC will release updated economic forecasts at its upcoming meeting. Every March, June, September and December, each FOMC participant produces new ‘Economic Projections’ for GDP growth, unemployment and the Fed’s preferred measure of inflation, changes in Personal Consumption Expenditure prices. At the September FOMC meeting, the ‘central tendency’ forecasts that exclude the three highest and three lowest estimates showed policymakers projecting GDP growth to rise from 2.0-2.3% in 2013 to 2.9-3.1% in 2014 and 3.0-3.5% in 2015. The strong pickup in activity in the next two years is partly based on this year’s sharp ‘sequestration’ spending cuts not being repeated. At the June FOMC meeting, however, officials were even more optimistic on growth in 2014, expecting the economy to expand by 3.0-3.5% next year. If policymakers decide to revise up their projections for GDP growth in 2014 at this month’s FOMC meeting – following stronger US releases during Q4’13 – it would suggest officials may be willing to cut asset purchases at a faster pace next year and thus end the Fed’s current round of quantitative easing earlier.

The speed of tapering will also depend on how the Fed sees unemployment and inflation. At the September FOMC meeting, policymakers’ central tendency forecasts for America’s jobless rate was 7.1-7.3% at the end of 2013, 6.4-6.8% in 2014, 5.9-6.2% in 2015, 5.4-5.9% in 2016 and 5.2-5.8% in the ‘longer run’. November’s jobs report shows the unemployment rate has already fallen faster than anticipated to 7.0%. The FOMC may revise its forecasts lower for unemployment as a result.

Stronger GDP and lower unemployment projections would – by itself – support the dollar. But FOMC officials may also show more concern about the low levels of inflation in the US economy. The Fed targets core PCE inflation to reach 2%. At the September FOMC meeting, the central tendency forecasts here were 1.2-1.3% by the end of 2013, 1.5-1.7% in 2014, 1.7-2.0% in 2015 and 1.9-2.0% in 2016. In October, however, core PCE inflation only rose 1.1%y/y. FOMC participants may downgrade their near term forecasts as a result. That may temper the Fed’s willingness to slow down asset purchases.

Third, the FOMC may decide to lengthen its forward guidance on future rate hikes. That may weaken the dollar. Currently, the Fed has committed to keeping the Fed funds target rate unchanged near zero unless the FOMC forecasts core PCE inflation will breach its 2.0% target and hit 2.5%y/y or if unemployment falls to ‘at least’ 6.5%. FOMC members are not projecting core PCE inflation to reach 2.0% until 2015 at the earliest. But unemployment on current trends may hit 6.5% in the next few months.

Fed doves including Bernanke, Vice Chair Yellen and New York Fed President Dudley are worried that the jobless rate is falling faster than expected because participation rates have fallen to 35 year lows. Thus, the unemployment rate is over-stating the health of the labour market and does not warrant the Fed to start raising interest rates in the near term. In his November 20 speech, Bernanke said the central bank could agree to keep interest rates unchanged even if the jobless rate fell well below the Fed’s current 6.5% threshold. Nevertheless, if FOMC officials want to make it clearer that the Fed funds target rate will not be raised for some time after the central bank finishes quantitative easing in 2014, policymakers may decide to lower the 6.5% unemployment threshold for future rate hikes.

If the FOMC agrees to reduce the threshold to 6.0% then it would signal the Fed is likely to still start raising interest rates before the end of 2015. That’s because the FOMC currently forecasts the US jobless rate will be 5.9-6.2% by the end of that year. A move from 6.5% to 6.0% would largely be in line with futures markets expecting the first Fed hikes in late 2015. The impact on the dollar would thus be modest. But if the FOMC was to cut the threshold from 6.5% to 5.5% then the impact on the dollar would be more adverse. Currently, the FOMC projects unemployment will be 5.4-5.9% at the end of 2016. Thus the Fed would be signaling that it could potentially see interest rates on hold for another three years.

Fourth, the Fed may surprise by deciding to cut interest on excess reserves (IOER) if FOMC members want to signal more clearly the Fed funds target rate will not be quickly raised once tapering starts. Currently, commercial banks hold around $2.5trn of excess reserves at the Fed and the central bank pays 0.25% interest. The October 29-30 FOMC meeting minutes said ‘most participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage’. Former Fed Vice Chair Blinder argued in a Wall Street Journal Article that the inclusion in the FOMC meeting minutes was significant as participants had generally been opposed to such a move. If the Fed does go ahead and cut its IOER rate to zero, the dollar would likely weaken at the surprise decision.

In short, the FOMC meeting in the week ahead presents upside and downside risks to the dollar in the near term. In the longer-term, however, the greenback’s direction is likely to be clearer as the strengthening US economy induces the Fed to reduce its asset purchases and enable the dollar to rise to 1.25 against the euro and 110 against the yen as quantitative easing finishes next year.


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