Will the US Dollar necessarily rise if minutes from July’s FOMC policy meeting reinforce the chance of a stimulus cutback in September? Perhaps not.

Talking Points

Australian, NZ Dollars Fell with Asian Stocks on Fed Policy Speculation Overnight
US Dollar May Fall if July’s FOMC Minutes Reinforce Status Quo “Taper” Outlook

The Australian and New Zealand Dollars underperformed in overnight trade, down as much as 0.5 and 0.8 percent on average against their top counterparts. The drop tracked a decline on Asian stock exchanges amid continued speculation surrounding the direction of Fed monetary policy ahead of tomorrow’s publication of minutes from July’s FOMC meeting.

As it stands, the consensus view seems to envision a move to reduce asset purchases by $10 billion at the September FOMC meeting. Price action over recent weeks suggests that rhetoric deviating from this status quo on the dovish side of the spectrum is likely to establish support for risky assets and weigh on the US Dollar. Alternatively, this framework implies the opposite effect if a hawkish tone is detected.

In the event that the Fed confirms the status quo, a somewhat counter-intuitive dynamic may emerge. As we discussed in our weekly forecast, the blueprint for such a scenario may have emerged last Thursday, when headline news-flow seemingly supportive of a September cutback in asset purchases proved negative for risky assets and the US Dollar alike.

The culprit may have been June’s TIC report, which showed a staggering $66.9 billion monthly capital outflow from long-term USD-denominated assets (notably Treasury bonds). This amounted to the largest monthly decline since August 2007 and occurred against a backdrop of volatility linked to the Fed’s signaling of its intent to slim down the QE effort.

This presents an interesting possibility: with about two-thirds of economists polled separately by Bloomberg and Reuters now agreed on the likelihood of a $10 billion “taper” in September, the US Dollar may reflect such a scenario already. Its confirmation may thus yield limited support on the basis of reduced USD dilution risk associated with smaller-scale monthly liquidity injections.

That leaves the greenback to respond to secondary considerations. One of these may be the response of large-scale holders of US Treasury bonds – like China, for example – to the looming exit of a major buyer underpinning prices (obviously enough, the Fed). June’s TIC data seems to suggest these investors may reduce their exposure to US debt. If FX markets interpret this in terms of ebbing demand for USD-denominated assets as QE is wound down, the benchmark currency may come under pressure.

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