US Dollar Set for Explosive FOMC…But Does it Rally or Collapse?
Fundamental Forecast for US Dollar: Neutral
Market heavily pricing in a Taper at Wednesday’s meeting, but unclear how far markets have adjusted for it
Despite the dramatic moves from Treasuries, carry trade, emerging markets; there has been little adjustment from S&P 500
Trade the US Dollar’s momentum following the FOMC decision using the Dollar Currency Basket
The event dollar traders – and really investors in all asset classes – have long waited for is finally upon us. Speculation surrounding the FOMC’s Taper decision has run rampant, spurring expectations and fear of an explosive reaction to a big shift in the market’s support structure. In fact, the discussion over this inevitable event has proven so prolific that we have already seen forecasts amongst economists and banks establish a clear consensus for a moderation of stimulus at the September meet while yield sensitive assets (like the benchmark US Treasury) have suffered sharp adjustments. Much of the actual impact an event like this has comes through the ‘surprise’ factor, but is there any surprise left in this event? Could this be a ‘buy the rumor, sell the news’ event for the dollar?
To establish how the market responds to the Federal Reserve’s policy decision, we must establish what an ‘inline’ outcome would be. Over the past weeks and months, the members of the central bank’s board – both voters and non-voters – have repeatedly stated their support for Chairman Ben Bernanke’s timeline laid out after the June meeting – one of the quarterly events that was accompanied by updated forecasts and the press conference. With that platform, Bernanke stated that it was likely that they would begin reducing the $85 billion-per-month stimulus program (QE3) ‘later’ in 2013 and end sometime in mid-2014. Considering this is the last policy meeting with a schedule press conference until December, the first move this month would best fit the timeline.
Given the massive drop in Treasuries, mortgage backed security funds, emerging markets, gold and other yield-sensitive assets; it is clear that a tapering is being priced in. Yet, it isn’t clear as to how certain the market is of the size. The New York Federal Reserve’s survey of Primary Dealers (large financial institutions that must deal in Treasury auctions and are considered by the central bank a barometer for the market) showed expectations of a $15 billion reduction at the first meeting and an aggressive pace after a similarly-sized move in December. However, a recent Bloomberg poll showed economists only expect a $10 billion cut to Treasury purchases only. Clearly there debate over this outcome and some adjustment will follow.
In the scale of scenarios, themost overwhelming surprise would come from a decision to hold the program at $85 billion per month. An 80 percent surge in the benchmark 10-year Treasury yield in the span of just four months (not to mention the move from other global sovereign debt) shows a significant shift in expectations and positioning. If this unlikely scenario were realized, risk-sensitive assets that are dependent on the environment of artificially-low volatility would rally. However, such an outcome would be known to be a simple delay and not a permanent freeze on the necessary withdrawal. As such, risk benchmarks still hovering near record highs are unlikely to find much follow through. Carry trades that have seen an improved yield outlook (NZDUSD and AUDUSD) will progress further. Yet, perhaps the most prolific short-term rebound would come on part of US government bonds. Such a dramatic drop these past months can lead to an equally spectacular rally. In turn, a flood of capital looking to buy cheap Treasuries, could actually lift the dollar.
A Taper of approximately $10 billion along with increasingly dovish forward guidance – an effort to ‘reassure’ is guaranteed – would be the most difficult outcome to account for. There has been exceptional adjustment to this outcome in some markets but relatively little in others. The immediate volatility for the dollar with this scenario would be the most restrained. However, looking at the underlying changes this would lead to, it is likely to eventually support the dollar. An initial unwinding of ‘Taper’ premium from the greenback will be followed with counter-balances by other central banks, a rise in presumed risks and an outlook of competitive yield growth in the US.
For the most decisive support for the US dollar, a $15 billion or larger reduction alongside a status quo tone would carry the most weight. The mechanics in supporting the currency through this outcome require we tap into something far more elemental: market-wide investor sentiment. A glaring holdout to the Taper adjustment we have seen these past months, US equities led by the S&P 500 are perhaps the poster-child of ‘moral hazard’ – taking on excessive risks as participants feel they are will be absorbed by someone else. This is where the dollar’s potential really lies. If record leverage translates into disorderly unwinding the safe haven will soar. – JK
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