Today’s hawkish FOMC statement breathed new life into the U.S. dollar and looking ahead, we anticipate further gains in the greenback. From their pre-FOMC levels, the EUR/USD dropped more than 100 points while USD/JPY soared by approximately the same amount. Before the end of next week, we expect EUR/USD to test and break its 2-year low of 1.25 and USD/JPY to test 110.
Going into today’s meeting, the Fed was widely expected to end Quantitative Easing but barely anyone anticipated such a significant upgrade to their labor market assessment. In fact, the dollar traded lower ahead of the decision because most market participants were looking the central bank to express concerns about falling inflation expectations, which would have been bearish for the greenback. While the Fed acknowledged the recent decline in price pressures, they viewed it as temporary and instead spent most of the statement talking about the uptick in jobs. Here are our main takeaways from today’s Federal Reserve’s monetary policy announcement:
1. Fed remains on track to raise rates in mid 2015
2. The “considerable time” language will most likely be dropped / changed next month
3. They can no longer turn a blind eye to the improvements in the labor market
4. They view the decline in price pressures as temporary
5. They are not worried about the slowdown in global growth
6. Kocherlakota dissents but Plosser and Fisher voted for today’s actions
Today’s statement is clearly a vote a confidence for the economy because not only did the Fed fail to share the market’s concerns about low inflation but they went one step further by upgrading their assessment of the labor market. The Fed no longer sees “significant” underutilization of the labor market resources and instead acknowledged the improvements including solid job gains and lower unemployment rate. In addition, there was no mention of the slowdown in global growth hitting the U.S. economy.
Although the Fed could have waited until December to sound more upbeat about jobs, there’s a good chance policymakers wanted to take advantage of the recent decline in rates. The Fed did an excellent job of smoothing the market’s reaction to the end of QE by outlining their protocol well in advance and now they are doing the same by slowly upgrading their assessment and preparing the market for a rate hike next year. While they preserved the “considerable time” language in the FOMC statement this month, come December, this line could be dropped as well.
Looking ahead, the trade in the FX market still centers around policy differentials. Today’s decision resets expectations for a mid 2015 rate hike by the Fed. In contrast, more easing is expected from the Bank of Japan and the European Central Bank. Tonight, the BoJ is widely expected to admit that it will take longer to reach their inflation target, which should lead to further weakness in the yen. While we have been looking for long-term dollar strength for some time, we are now also looking for short term gains and all of this plays into our new calls for 1.24 EUR/USD and 110 USD/JPY.