Fed Preview: What to Expect for USD

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With equities rising and the U.S. dollar weakening, the price action in the financial markets tell us that investors are positioning for a dovish and dollar negative outcome from the FOMC meeting. This sentiment is a bit surprising considering that less than 2 weeks ago, Fed Chairman Ben Bernanke downplayed the weakness of the U.S. labor market and reset the market’s expectations for more stimulus in the process. Investors are clearly skeptical about Bernanke’s nonchalant attitude on non-farm payrolls and believe that even if there is no QE3 tomorrow, the Fed will reassure the market that monetary policy remains extremely accommodative and they are ready to do more if necessary. The dollar will weaken if Bernanke admits that QE3 is still a possibility, but if he spends more time talking about the distortion that the warm weather had on U.S. data, the dollar should rise. We do not expect Wednesday’s FOMC announcement to be one of those gaming changing monetary policy events but with Bernanke holding a press conference and the Fed releasing their revised economic projections, it could still be a volatile trading day. The actual decision about monetary policy should be an easy one – extend Operation Twist and nothing else. If the anti-austerity party won the Greek elections causing a sell-off in financial markets around the world, the FOMC decision would be a tougher call. The rest is more complicated as the high level of unemployment could alter the central bank’s projections. Bernanke’s comments will also be important and hopefully this time around he has learned to clarify instead of confuse traders because in this past, his views have conflicted from the Fed projections.

Here’s the schedule for tomorrow:

12:30pm ET / 16:30GMT – FOMC Rate Decision
2:00pm ET / 18:00 GMT – Fed Releases Projections for Economy and Fed Funds Rate
2:15pm ET / 18:15 GMT – Bernanke Holds Press Conference

Eight weeks have passed since the last monetary policy meeting in April and here’s a look at how the U.S. economy has changed. While some parts of the housing market have shown signs of life, there has been broad based deterioration in the rest of the economy. The sluggish pace of job growth and sharp decline in equities made consumers more nervous and less willing to spend. The stronger dollar and lower commodity prices also eased inflationary conditions, giving the Federal Reserve further room to ease. The only question is will they.

Ask anyone one on the street whether the U.S. economy could use a jolt of stimulus and the answer will be an overwhelming YES! The labor market, housing market and the stock market is in terrible shape and if Europe continues to wreck havoc on global demand, the meager amount of growth that the U.S. economy enjoyed this past year will become nonexistent. Yet the leadership at the Federal Reserve refuses to admit that more needs to be done even though the weak data points are staring at us in the face. The S&P 500 dropped as much as 7 percent since the beginning of May before recovering. In April, the U.S. economy added 77k jobs and last month, job growth slowed to 69k. Instead of acknowledging this deterioration, Bernanke tried to chalk it up to the weather.

Why in the world would be Fed hold back now when the labor market has taken a turn for the worse?

Here are 3 reasons:

#1 – Despite the 25% fall in oil prices since February, inflation expectations haven’t declined materially because investors actually expect the Fed to increase stimulus.

#2 – Even with the pullback in the labor market, consumer spending remains firm and there is enough positive economic data to justify saving their bullets for a more desperate time in U.S. economy. In other words, there is no need to bring out the big guns quite yet.

#3 – There have also been many disputes over the effectiveness of Quantitative Easing (What is Quantitative Easing?). The Fed argues that QE1 and QE2 eased credit, boosted growth and consumption and slowed the decline in U.S. stocks. But Quantitative Easing failed to revive the economy and QE2 was less than effective than QE1 while more QE could stoke inflationary pressures in the future.

“80% Chance that the Fed will have to resort to QE3 sometime this year – it may not be this Wednesday but it will be in 2012.

But if Europe’s problems continue to pressure the financial markets and unemployment refuses to decline, the Federal Reserve could find themselves with their back to the wall and no choice but to introduce another round of asset purchases. We believe there is an 80 percent chance that the Fed will have to resort to QE3 sometime this year – it may not be this Wednesday but it will be in 2012. If Bernanke truly believes that the warmer weather artificially pushed up job growth in the winter, leading to a retracement in spring, then he will want to see another month of non-farm payrolls before making a decision about QE3.

The Compromise – Extending Operation Twist

However Bernanke won’t leave us completely empty handed on Wednesday. Ten days after the FOMC meeting, Operation Twist (What is Operation Twist?) is scheduled to expire. Given the weakness of the labor market, there is a 99 percent chance that Bernanke will continue to do the twist for another 6 months. If you don’t remember, that involves selling short term bonds and buying long term bonds to keep yields low. Last week, the second most powerful person at the Fed, Janet Yellen, Vice Chair of the Federal Reserve Board of Governors said point blank that “If the (Fed) judges that the recovery is proceeding at an insufficient pace, we could undertake portfolio actions, such as additional asset purchases (QE3) or a further maturity-extension program (Operation Twist).” Given Bernanke’s skepticism about the need for QE3, Operation Twist would be the best compromise. This way the market won’t leave empty handed and the Fed won’t have to show all of its cards.

But Doing Twist Alone Won’t be Enough

The key question then becomes whether Operation Twist will be enough to satisfy the market and the clues will lie in Bernanke’s post monetary policy meeting press conference. If he hints that Operation Twist is the first step to more stimulus then equities and currencies will rally. The U.S. dollar will weaken but for good reasons and no one will complain about it. If Bernanke extends Operation Twist but remains noncommittal about the need for more policy accommodation, which is the most likely scenario, investors will bid up the dollar in disappointment. We’re hoping that Bernanke won’t cause more confusion than clarity like he did back in April but given his track record of putting his foot in his mouth we’re not too optimistic.

Investors should expect it to be a VERY busy week in the forex market, with G20 leaders meeting right before the Fed announcement.

Here’s a look at how the EUR/USD, S&P 500 and US 10 year yields performed after the first and second round of Quantitative Easing. As you can see, all 3 increased when QE began and trailed off near the end

Kathy Lien
Managing Director

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