How Fed’s Choice to Play it Safe Impacts the Dollar

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Daily FX Market Roundup 09-18-13

How Fed’s Choice to Play it Safe Impacts the Dollar
GBP: Soars on Less Dovish BoE Minutes
EUR Above 1.35, Watching European Politics
Risk Appetite Fuels Strong Rally in Commodity Currencies
NZD – Q2 GDP Numbers on Tap
AUD: Supported by Stronger Data
Drop in 10 Yr Yields Weighs on USD/JPY

How Fed’s Choice to Play it Safe Impacts the Dollar

The Federal Reserve decided to play it safe today by keeping their asset purchase program unchanged. The decision caught the market by surprise as only a small minority of economists expected the central bank to refrain from tapering. When the announcement was made, stocks climbed to a record high, the price of gold soared, Treasury yields plunged and the dollar dropped to multi-month lows against many major currencies. The magnitude of the market’s reaction shows that the announcement was completely unexpected and how severely the market was positioned the other way. The U.S. dollar sold off aggressively and we think the central bank’s decision ushered in a new wave of risk appetite that could mean further losses for the greenback. At this stage, there is a very good chance that Bernanke will leave the choice to taper to his successor. In fact, as soon as the Fed decided to stand down, the market was buzzing with speculation about whether Janet Yellen had a big hand in this decision.

The argument for tapering centered around the 7% unemployment rate target that Bernanke mentioned in June but today the Fed Chairman backed off this call, choosing instead to say that there is “no magical number” when it comes to the jobless rate. He even admitted that the jobless rate can be an inaccurate measure of labor market conditions and what the central bank really wants to see is an overall improvement in the labor market. By telling everyone they are worried about sluggish payroll growth, the central bank effectively changed the conversation from the Fed must taper before the end of the year to the possibility of no change until 2014. Having boxed themselves in and inappropriately leading the market on, Bernanke is still learning from his mistakes. Attempts at clarity can lead to confusion if they are not 100% sure the signal they are giving the market is the right one.

The bond market’s reaction to Bernanke’s comments about tapering in July scared the Federal Reserve back into their shells and they feared that if they tapered today, it would lead to a further tightening of financial market conditions, which the economy may not be able to handle given the fiscal restraints on growth. So instead, they opted to wait for more evidence of progress in the economy before adjusting the pace of asset purchases. There were a number of changes to the FOMC statement but the bottom line is their outlook deteriorated slightly from July. Along these lines, the Fed cut its 2013 and 2014 GDP forecasts quite substantially even though their unemployment rate forecasts were lowered slightly.

By holding monetary policy steady today, the central bank is effectively telling the market that they are worried about the U.S. recovery and while tapering is inevitable, these concerns will delay the move. We have seen quite a bit of position adjustments today with U.S. 10 year yields dropping more than 15bp and we believe that these adjustments will continue leading to further weakness in the U.S. dollar. Both the EUR/USD and GBP/USD have broken through important resistance levels and we expect another 1.5-3% rally for each of these pairs. While the losses in USD/JPY have been more moderate, there’s scope for a run to 96 in the near term.

GBP: Soars on Less Dovish BoE Minutes

Between the less dovish Bank of England minutes and the Federal Reserve’s decision to keep asset purchases unchanged, the British pound rose to its strongest level against the U.S. dollar in 7 months. Not only did sterling break through the pivotal 1.60 level but it also cleared 1.61 and appears to be on its way to test 1.62. From its current levels, the next resistance is actually 1.6175, an area that the currency pair failed at numerous occasions in late 2012. Fundamentally, sterling should experience further gains against the dollar as investors price in earlier tightening by the BoE and delayed tapering by the Fed. While we also feel that the GBP/USD will extend higher in the near term barring any surprisingly large decline in retail sales, which are scheduled for release tomorrow, it is important to remember that the Fed has simply delayed a move and they will inevitably act before the BoE. Nonetheless, all 9 monetary policy committee members voted to leave their Quantitative Easing program unchanged, which means the central bank as a whole has grown less dovish with Miles voting against an increase in QE. U.K. retail sales are scheduled for release tomorrow and this is the only report on the calendar that has the potential to drive the currency lower. According to the British Retail Consortium, consumer spending growth slowed in the month of August.

EUR Above 1.35, Watching European Politics

Thanks to the FOMC announcement, the EUR/USD broken through 1.35, hitting its strongest level since the month of February. No major economic reports were released from the Eurozone and so far, we have not received word on whether the Italian Senate has officially rejected a recommendation by a senior PLD member to confirm Berlusconi as a senator. The former Italian Prime Minister vowed to stay in politics even if he is expelled from the Senate but what was interesting about his speech today was that he refrained from threatening to pull his party out of the coalition government. With the FOMC meeting now behind us, European politics are in center focus. Aside from the Senate vote, Germans are headed to the polls this weekend and they are widely expected to reelect Angela Merkel as Chancellor for a third term. She’s leading in the polls and at this stage there is little risk that she lose and this prospect should lend support to the euro. With no data expected on Thursday, we expect EUR/USD to trickle higher as investors continue to digest the FOMC announcement. The Swiss National Bank also has a monetary policy decision tomorrow and no changes are expected because there has been very little momentum in Switzerland’s economy.

Risk Appetite Fuels Strong Rally in Commodity Currencies

The Australian and New Zealand dollars were the biggest beneficiaries of U.S. dollar weakness but the Canadian dollar wasn’t far behind. Not only did the sell-off in the greenback boost commodity currencies but it also lifted commodity prices. The continuation of easy monetary policy in the U.S. helped extend risk appetite and in turn high beta currencies. While the NZD experienced more significant gains, Australia reported the stronger data overnight. Leading indicators ticked up in the month of July according to Westpac and the Conference Board. New Zealand on the other hand reported a larger current account deficit in the second quarter but thankfully the widening was less than economists had anticipated which helped the NZD hold onto its gains. Tonight New Zealand GDP numbers are scheduled for release and despite the hawkishness of the Reserve Bank, weaker trade activity between April and June may have dampened growth.

Drop in 10 Yr Yields Weighs on USD/JPY

With U.S. 10 year yields dropping more than 15bp, the U.S. dollar fell over than 1 against the Japanese Yen. We are actually a bit surprised by the measured pace of the decline compared to other currencies and expect further losses in the coming days. While the Fed will eventually taper, their decision to maintain the same pace of monthly bond buys should encourage short yen and long dollars traders to unwind their positions. The simultaneous sell-off in USD/JPY and rise in high beta currencies like the EUR, GBP, AUD and NZD have kept the volatility in the Yen crosses at minimum. While Nikkei futures have followed the Dow higher, the rise in Yen could limit its gains/ Japanese trade numbers are scheduled for release this evening and the country’s trade deficit is expected to narrow on an adjusted basis. Stronger exports should be offset by weaker imports.

Kathy Lien
Managing Director

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