Dollar Response To FOMC Hinges On 2 Variables

How Dollar Responds to FOMC Hinges on 2 Variables

The U.S. dollar and Treasury yields traded lower ahead of Janet Yellen’s very first monetary policy meeting as Federal Reserve Chairwoman. She has big decisions to make that could set the tone for her time at the Fed but luckily investors have a good grasp of her potential announcements. It is widely believed that the central bank will reduce asset purchases by another $10 billion and drop its unemployment rate threshold in favor of qualitative guidance. The market has already priced in these changes, which leaves the U.S. dollar’s reaction to FOMC contingent upon 2 variables.

The first is what Qualitative Guidance looks like. When the Bank of England abandoned their unemployment threshold, they tied future policy tightening to the slack in the labor market. The current FOMC statement already contains some details on qualitative guidance. In the last statement, the central bank said other measures such as “labor market conditions, indicators of inflation pressure and inflation expectations and readings on financial developments,” will determine how long a highly accommodative monetary policy stance is maintained. If Yellen uses these indicators as measures of qualitative guidance, they will be specific enough for the market to understand that employment and inflation are the central bank’s primary focus and vague enough to provide no additional information on the timing of future rate hikes. If the central bank does not elaborate on these measures and simply ties forward guidance to what is currently in the FOMC statement, investors will be disappointed and the dollar’s reaction will be limited. For central banks comfortable with their current course of monetary policy, saying less could be doing more for the economy so this could be an ideal choice for Yellen. However if she chooses to be more transparent and provides more specifics or additional conditions, the dollar could have a more significant reaction.

The second will be the Federal Reserve’s latest economic projections. As these are hard numbers there is very little ambiguity. If the central bank lowers its 2014 GDP forecasts because of weak growth at the start of the year, investors could sell dollars if they interpret this to mean a more pessimistic outlook for the economy. If they leave their GDP forecast unchanged, it could be interpreted as a slightly more optimistic outlook for the rest of the year, which would be positive for the greenback. Their forecasts for the unemployment rate will also be lowered but we are not looking for any significant changes to the central bank’s inflation projections.

EUR Resilient in the Face on Ongoing Ukraine/Russia Crisis

The euro has been extremely resilient in the face of the ongoing crisis between Russia and the Ukraine. This morning, Russian President Vladimir Putin officially signed a treaty to accept Crimea into the Russian Federation and in a direct challenge to the West, the Russian government has moved fast to bring Crimea into its fold. Within 3 months, they expect the Ruble to replace the Ukrainian hryvnia as the local currency. Putin also announced plans to respond to US and EU sanctions with their own restrictions. Their complete rejection of the West’s calls to de-escalate tensions should have led to a flight to quality into U.S. dollars and out of euros but the EUR/USD held steady as investors latched onto the hope that Russia’s incursion into Ukraine will stop at Crimea. According to Putin, there is no need to break up Ukraine even further and if he stays true to his words, the tensions between Russia and the West could begin to fade and the improvement in risk appetite could be sustained. This mere possibility has already driven equities higher and kept the EUR/USD afloat. Unfortunately we feel this positive sentiment is still wishful thinking because sanctions from Russia could lead to a more aggressive response from the West. Russia has already been suspended from the G8 and could be isolated even further. They boosted their troops at the Ukraine border, raising concerns that they are poised for a quick invasion that explains why euro has given up its initial post Putin gains. So while Russia’s statement Tuesday could be positive for euro, actions speak louder than words and so far, there are plenty of reasons to believe that the crisis in Ukraine will worsen before it improves.

GBP: What to Expect for UK Budget, BoE Minutes and Employment Report

While the focus of the foreign exchange market Wednesday will be on the U.S. dollar and the upcoming FOMC rate decision, Wednesday is also a big day for the British pound. We look forward to release of the Bank of England minutes, UK budget and the latest labor market numbers. Starting with the minutes, there has been very little change in the economy between the last 2 meetings and therefore we do not expect any major changes in the central bank’s monetary policy bias. All policymakers are expected to have voted in favor of keeping interest rates and Quantitative Easing unchanged. In the minutes from the February meeting, the MPC tried to temper market expectations for tightening by saying there was room to absorb spare capacity before rate increases which remains true and should make its way into the March minutes. According to BoE Governor Mark Carney who spoke earlier Tuesday, rates will stay low for some time. This means the employment report will most likely have a larger impact on sterling than the BoE minutes. According to the PMI numbers, the labor market improved significantly last month, which suggests that jobless claims could fall by a larger amount, providing additional support to sterling. As for the UK budget, there will be a flurry of tax and spending changes. The OBR could also change its economic growth projections. If there are no groundbreaking announcements, the impact on sterling would be limited.

CAD Crashes on Dovish BoC Comments

The worst performing currency Tuesday was the Canadian dollar, which weakened against all of its peers. The loonie started the North American trading session strong thanks to a larger than expected increase in manufacturing sales but dovish comments from Bank of Canada Governor Poloz caused the CAD to tumble quickly and aggressively. Due to slower than expected first quarter GDP growth and low inflation, Poloz said he may have to reconsider the central bank’s neutral monetary policy stance. More specifically he said they can’t rule out further rate cuts if the downside risks to inflation increases. The BoC’s fresh concerns about the economy and consideration of additional easing sets them far apart from other central banks who are tightening monetary policy or beginning to remove stimulus. The CAD has reacted accordingly and we believe there could be further losses especially against the U.S., New Zealand and Australian dollars. In contrast, the improvement in risk appetite drove AUD and NZD sharply higher Tuesday. There was no data from New Zealand but the RBA released the minutes from its last monetary policy meeting. According to our colleague Boris Schlossberg “The tone of the minutes was generally upbeat with the central bank noting that it saw period of interest rate stability, assuming economy evolved as expected. The RBA noted that indicators were positive for consumption, housing, investment exports and business conditions suggesting that the recovery Down Under is well on its way.” New Zealand current account numbers were scheduled for release Tuesday evening along with Australia’s Westpac Leading Indicators report.

JPY: Significant Improvement in Trade Activity Expected

Led by the sell-off in U.S. Treasury yields, USD/JPY traded lower ahead of the FOMC rate decision. This put pressure on all of the Yen crosses with the exception of NZD/JPY, which was driven higher by NZD strength. Machine tool orders were the only piece of Japanese data released Tuesday and the in line report had very little impact on the currency. The Ministry of Health Labor and Welfare also revised down wage growth from 0.4% to 0.1%. We are concerned about the level of consumer spending ahead of the consumption tax increase but the government does not share these worries. Earlier this week, the Cabinet changed its economic assessment to say that “a last minute rise in demand before a consumption tax increase is intensifying.” This suggests that they see evidence of increased consumer consumption. Economists were looking for a significant improvement in Tuesday night’s trade balance and they attribute their more optimistic outlook to stronger domestic demand. Bank of Japan Governor Kuroda and policymakers Kiuchi and Sato were scheduled to speak Tuesday evening and they were expected to express continued confidence in the outlook for the economy.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.