Crucial Week for the Fed & US Dollar

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Investors are selling dollars this morning against all of the major currencies with the exception of the British pound. USD/JPY in particular traded within a few pips of an important support level that we have been watching for weeks – the December 101.63 low. Whether this support holds or breaks in a meaningful way will be determined by the ISM reports, non-farm payrolls and speeches from Federal Reserve Presidents this week. The next 5 days will be extremely busy in the foreign exchange market. The U.S. central bank decided to taper asset purchases last week but the main reason why the greenback traded higher was because of a flight to quality caused by the turmoil in emerging markets. While the movements of the dollar could be still be affected by developments in Turkey, Argentina, South Africa and Russia, the lack of big moves this morning allowed investors to shift their focus back to the U.S. economy. A rebound in non-farm payrolls is widely expected but investors are keeping a very close eye on the unemployment rate, which is nearing the Federal Reserve’s 6.5% threshold.

Over the past 2 months the U.S. jobless rate has fallen rapidly and if it maintains its current pace of improvement, it could drop to 6.5% this week. This possibility has led many people to wonder what the central bank will say or do if their threshold is reached on Friday. We don’t expect much response from the Fed because they have been downplaying the significance of the threshold for months now. In fact, the Fed Presidents who are scheduled to speak this week will probably take the opportunity to stress that 6.5% is a threshold and not a trigger for a rate hike. Higher rates is in the very distant future for the central bank and reasserting their intention to keep rates low for an extended period of time will be their number one priority. Of the 6 central bank Presidents scheduled to speak, Plosser and Tarullo are the only voting members of the FOMC this year and they are on the opposite sides of the dove / hawk scale.

By tapering asset purchases this week, the central bank has already responded to the improvements in the labor market. The Fed could reduce its unemployment rate threshold but a decision will not be made until March. Also, reducing the threshold may not be a smart tactic for Janet Yellen because it would hold the central bank to another hard metric. Back in December Bernanke said that forward guidance could be changed to a more qualitative than quantitative measure, a view we believe Yellen shares. Tying monetary policy to the unemployment rate created more trouble than solutions for the central bank. However if the unemployment rate drops to 6.5%, we still expect the dollar to rise because it would ensure that the Fed would stay on track and taper asset purchases at every successive meeting.

This is a pivotal week for the Federal Reserve and the U.S. dollar because the level of improvement in the unemployment rate will determine the amount of pressure on the central bank to make changes at their next meeting. Non-farm payrolls are not scheduled for release until Friday. Between now and then, the dollar will take its cue from other labor market indicators that will help set expectations for payrolls like the ISM non-manufacturing index, ADP and Challenger Layoff reports.

Kathy Lien
Managing Director

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