It is all about the U.S. dollar today. Jobless claims rose to their highest level in 8 weeks while producer prices jumped 1.7% in the month of August. Weaker labor market data and hotter inflation reflect the challenges that the U.S. economy faces. While inflationary pressures rose the most since November, the increase was caused entirely by higher energy prices. Yet this morningâ€™s producer price and jobless claims reports were nothing more than sideshows to the main event of the week â€“ the Federal Reserveâ€™s monetary policy announcement. This month we have not one but three opportunities for the Fed to engage the markets. Back in simpler times, the Federal Reserve released its monetary policy statement at 2:15pm ET and let the market interpret as they pleased. However with the unprecedented shocks to the global economy necessitating unconventional monetary policy responses, the Federal Reserve felt the need to be more transparent by taking questions from the press at least four times a year.
Hence, back in early 2011, the Federal Reserve decided to change up the FOMC meetings. Four times a year, the Fed operates with the following schedule:
12:30pm ET (16:30 GMT) â€“ Release of FOMC Statement
2:00pm ET (18:00 GMT) â€“ Release of Economic Data and Interest Rate Projections
2:15pm ET (18:15 GMT) â€“ Bernanke Conducts Press Conference with Q&A Session
While the Fedâ€™s goal is to reinforce the message every step of the way, in reality, these events may end up creating more confusion especially when Bernankeâ€™s views deviate from the Fedâ€™s forecast changed (which has happened in the past). For currency traders, this provides us with 3 distinct opportunities for volatility in the U.S. dollar. Hereâ€™s what we expect for each of the 3 Fed events today:
Act One: 12:30pm ET (16:30 GMT) â€“ Release of FOMC Statement
If the Fed chooses to change their rate guidance or embark on a third round of Quantitative Easing, the market will find out as soon as the FOMC statement is released. Both decisions will be detailed in the statement and investors will know immediately how aggressive the central bank has chosen to be. The benchmark against which QE3 will be measured is the last quantitative easing program, which was $600 billion in size and occurred over a 7 to 8 month period. When the Fed first announced QE2, this is what they said:
The Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
We will be looking for similar language in todayâ€™s FOMC statement or at least compare the new language to the language above. If the Fed were to announce QE3, thereâ€™s no doubt that the asset purchase program would extend into January, which is beyond the elections and the fiscal cliff hump. At that time, they will probably reassess and see if program needs to be expanded. The smaller the size and span of time that the commitment covers, the better it is for the dollar whereas open-ended QE, which is a low probability scenario would probably be very bearish for the greenback. If the Fed passes on QE and only makes changes to their rate guidance, the dollar would most likely soar as investors reverse their QE3 bets. Aside from Quantitative Easing, we are also looking for the central bank to alter the rate guidance in the FOMC statement by extending their low rates pledge from late 2014 to mid 2015. If they go beyond mid 2015, it will be bearish for the dollar.
Act Two 2:00pm ET (18:00 GMT) â€“ Release of Economic Data and Interest Rate Projections
With the regards to the economic forecasts, it is important to know that starting this month, the Fed will provide forecasts going as far out as 2015. Given the underwhelming performance of the U.S. economy, we expect the Fed to downgrade its GDP forecasts for this year and next, hold steady or upgrade its unemployment rate forecast slightly and decrease its inflation forecasts. Weak demand will most likely keep price growth muted. A downgrade to growth and upgrade to the unemployment rate forecasts will be negative for the U.S. dollar. When the latest numbers are released at 2:00pm ET, these figures are what you want to compare them with:
Final Act : 2:15pm ET (18:15 GMT) â€“ Bernanke Conducts Press Conference with Q&A Session
The final act of Bernankeâ€™s press conference is where things get can even more interesting. Investors will be listening in closely to see if the central bank telegraphs any future plans for monetary policy. In our opinion, with the November elections only 2 months away, the central bank wonâ€™t want to commit to any further actions beyond what they announce later today. Its smarter to regroup, get a sense of how the new Administration will handle the fiscal cliff before deciding their next course of action. With this in mind, it will be tough for Bernanke to be elusive. The Fed Chairman is known for saying too much or dropping too many hints about their bias for monetary policy so we would not be surprised if he did so tomorrow as well. Either way, keep your ears open for any clues about their plans for October and beyond.
The U.S. dollar continued to weaken against the Japanese Yen and other major currencies, which tells us that investors are prepared for QE3 from the Federal Reserve. Knowing this, savvy traders will immediately wonder how much impact a third round of Quantitative Easing can really have if the market has already discounted the announcement. While it is true that most economists and investors expect the central bank to ease tomorrow, we believe that the dollar could fall further if the Fed pulls the trigger on QE3. Thereâ€™s still some skeptics out there who are worried that the election could handcuff the Fedâ€™s hands or that the central bank simply doesnâ€™t have the guts to make such a big decision when data has been underwhelming but not abysmal. There is also a subset of investors who believe in QE3 but donâ€™t want to initiate any new positions until the announcement is actually made. Perhaps thatâ€™s the smartest course of action considering that the size and scope of QE3 is still up in the air.