Will the Fed Deliver Any Surprises at the FOMC Meeting?

Last updated 8/11/2009 10:00 AM ET (GMT -5) 4 Comments

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Kathy Lien

Director of Currency Research, GFT

We have seen nothing but consolidation in the forex market since the much better than expected non-farm payrolls report on Friday. Profit taking on dollar short positions continued as currency traders reduce risk ahead of the FOMC announcement. Non-farm productivity picked up but unit labor costs fell in the second quarter. The employment report last week was very good but after such a sharp economic contraction, currency traders have a good reason to be skeptical of the recovery in the U.S. economy. Everyone has been holding their breath for some sort of confirmation that things are getting better and this confirmation may come in the form of encouraging words from the Federal Reserve or a solid retail sales report. Wednesday will be the first test of whether the dollar’s strength can be sustained with the Federal Reserve delivering their monetary policy decision in the afternoon.  With Fed Fund futures pricing in a rate hike next year, there are high expectations.

Traders will be looking to the Fed for answers to 3 critical questions:

1) Will the Asset Purchase Program be Increased?

2) Has the Economy Improved Enough to Warrant an Upgraded Assessment?

3) Is it Time to Talk about Exit Strategies?

At the last FOMC meeting in June, the Fed disappointed the market by avoiding any talk of an exit strategy. Interest rates were left unchanged at 0.25 percent, but leading up to the meeting, there was stabilization in economic data, equity and bond markets. Other central banks talked about the criteria for removing stimulus and Bernanke chimed by mentioning that he is focusing on employment and capacity utilization. However at the time, the U.S. central bank wanted to give the market more time to respond to the massive fiscal and monetary stimulus.

Since June, the U.S. economy has stabilized even further with the Dow Jones Industrial Average rising 12.5 percent, job losses tempering and the pace of contraction slowing. There is even a good chance that the U.S. economy will grow in the third quarter. However in this type of market environment, it pays for the Fed be more cautious to avoid fueling excess optimism. Therefore we do not except the Federal Reserve to rock to boat like the Bank of England or the Bank of Canada who are on completely opposite sides of the spectrum. In fact, other than the possibility of a marginally more optimistic tone, we do not anticipate any major changes to the FOMC statement. 

1)      Will the Fed Change their Asset Purchase Program?

In the past, many people have compared the Federal Reserve’s actions to the Bank of England. However don’t expect the U.S. central bank to follow in the footsteps of the BoE by increasing the size of their Quantitative Easing Program. Unlike their peers across the Atlantic, the Fed believes that the worst is over and the risks to growth are more balanced. The BoE has also been heavily criticized for overshooting their Asset Purchase Program and we are certain the Fed doesn’t want to fall under the same scrutiny. However the TALF program expires at the end of the year. A number of Congressmen have already asked the Fed to extend the program “no later than mid-August.” The central bank is under pressure to acquiesce and if they do decide to extend the expiration date, it would be perceived a dovish action that could reverse some of the gains in the U.S. dollar. 

2)      Has the Economy Improved Enough to Warrant an Upgraded Sentiment?

Since the last FOMC meeting, we have seen a broad based improvement in U.S. economy. Second GDP contracted by 1.0 percent compared to 6.4 percent in Q1 while non-farm payrolls fell by -247k compared to -443k in June. Consumer spending has increased and the housing market has continued to stabilize. However there are pockets of weakness in the service sector, consumer confidence and income growth. For these reasons, we expect the Fed to remain only cautiously optimistic. We will be looking to see if the Fed changes or drops their statement that “the pace of economic is slowing” and” economic activity is likely to remain weak for a time.” If either of these statements is upgraded, it should fuel further gains in the dollar, boosting rate hike and recovery expectations. The table at the end of this article illustrates how different sectors of the U.S. economy have changed since the last monetary policy meeting. 

3)      Is it Time to Talk about Exit Strategies?

With Fed Fund Futures pricing in a 79 percent chance of a rate hike in March, the bar is set high for the upcoming FOMC meeting. The Bank of Canada has already announced that the economy is emerging from recession and it will up to Fed to follow suit with either equally positive comments or an indication that it is time to stop purchasing government bonds. As it stands now, the Federal Reserve expects to finish their $300 billion Treasury purchase program by autumn. If they let this program run out, nothing changes. If they decide to stop their purchases sooner, it would be perceived as a move towards an exit strategy and in turn be dollar bullish. In recent weeks, Bernanke has also tried to reassure investors that the central bank has the tools to contain inflation risk when the economy starts to recover. This includes allowing the balance sheet to shrink naturally, raise interest rates, and conduct reverse repo operations. Of course we do not expect the Fed to explicitly outline their exit policy in the statement but they could prepare the market for a rollout of reserve management tools. 

Source: Bloomberg

As you can see, a lot rides on the upcoming FOMC announcement.   If the script remains the same, it would be disappointment but if the Fed satisfies the market by being more optimistic, we could see the dollar resume its gains against the Japanese Yen. The same could be true for the dollar against the euro if bond yields rise further on the heels of the FOMC decision.

Comments (4)

Shahrokh

August 12, 2009 at 10:17 AM ET

Hello dear
I like it.that was a good blog.Thank You!

Shahrokh

August 12, 2009 at 10:17 AM ET

Hello dear
I like it.that was a good blog.Thank You!

Shahrokh

August 12, 2009 at 10:17 AM ET

Hello dear
I like it.that was a good blog.Thank You!

Shahrokh

August 12, 2009 at 10:17 AM ET

Hello dear
I like it.that was a good blog.Thank You!

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.