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Will the FOMC be Hawkish Enough to Satisfy Dollar Bulls?

Last updated 3/15/2010 1:31 PM ET (GMT -5) 2 Comments

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Kathy Lien

Director of Currency Research, GFT

The U.S. labor market is improving, consumers are spending and the manufacturing sector is chugging along. With this backdrop, the Federal Reserve will decide tomorrow whether to recognize the improvements in the U.S. economy and signal additional plans to unwind emergency measures or to remain at status quo by keeping the FOMC statement virtually unchanged.  Traders have been buying dollars on the hopes that the Fed will grow more optimistic and we believe they should but as a central bank, they will have to carefully balance the risks and rewards of inserting language that would surely impact the market’s expectations for monetary policy.  The central focus of this upcoming meeting will be on two words – “extended period.”  If the Fed decides to drop the phrase, the dollar will probably rally as the Fed’s hawkishness satisfies dollar bulls but if they leave the phrase intact, traders will most likely express their disappointment by selling dollars.  Another key factor to watch is the number of members who dissent and say the phrase is no longer needed.  As usual, interest rates should remain unchanged at 0.25 percent.  

What will be the Tone of the FOMC Statement?

The primary reason why we believe that the Fed could grow more optimistic is the prospect of strong job growth in March.  Non-farm payrolls fell much less than the market had anticipated in February and with jobs affected by the snowstorms set to be added back this month, there is a strong possibility of positive job growth in March.  The improvement in the labor market should also encourage consumer demand, particularly given the rise in retail sales for everything except for autos.  There have been many areas of improvement since the January monetary policy meeting and if the Fed doesn’t want to fall behind the curve, they could choose to acknowledge the improvements tomorrow.  At the same time however, they could remain cautiously optimistic because consumer confidence has deteriorated.  Yet the Fed could also choose to wait for further improvements in retail sales before committing to a tightening cycle.  Inflationary pressures are relatively modest and it is unclear whether the pace of expansion in the manufacturing sector has slowed.  As a result, the Fed may want to wait for more signs of solid economic growth before tinkering with their outlook on interest rates.  With such a difficult conundrum, we believe the Fed will err on the side of caution by growing slightly more optimistic in their economic outlook, but keep the phrase “extended period” in the statement, which could be initially negative for the dollar.  In the long run however, compared to European central banks, the Fed is still closer to raising interest rates and therefore the sell-off in the dollar should be limited.  

Number of Dissenters

Don’t forget to also keep an eye on the number of dissenters.  Back in January, Kansas City Fed President Hoenig voted against the policy action.  He believed “that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.”  If additional policymakers dissent, it would be a sign of increasing hawkishness within the Fed.  Most Fed officials have said that interest rates will remain at low levels for an extended period of time but late last month, Fed President Evan provided some clues on what this phrase really means.  In a TV interview, he said, “extended period of time (to him) means 3 to 4 FOMC meetings.” Considering that Evans is generally perceived as one of the more dovish members of the FOMC, his timing for rate hikes should not be ignored. This means the Fed could be looking to raise rates at their June, August or September meeting which is in line with our internal timeframe for an end of the third quarter, beginning of the fourth quarter rate hike.  

How to Trade FOMC

Trading the Fed meeting is always difficult because in addition to a decision on rates, the tone of the FOMC statement also affects how the dollar trades.  Rather than immediately jumping into the market after the announcement, we have found that in 8 out of the last 11 times that the Federal Reserve has met, the move in the EUR/USD during the U.S. trading session continues into the Asian and London sessions.  More specifically, the dollar’s move between 2:15pm and 4pm NY time tends to follow through from 4pm to 12pm EST (noon) the following day.  The table below illustrates the reaction in the EUR/USD from 2:15 to 4pm on FOMC day and from 4pm to 12pm EST the next day.  In the 2 hours after the January FOMC meeting, the EUR/USD fell 0.11 percent and then from 4pm to 12pm the next day, it fell another 0.39 percent.  For forex traders that may not know how to interpret and trade FOMC, it may be better to wait and see how the market reacts before jumping in because the immediate reaction has a historically good chance of continuing.  

Source: FX360.com

Furthermore, the following chart illustrates the EUR/USD& #8217;s reaction following the January FOMC announcement.  As you can see, there was sharp volatility immediately after the announcement, then a brief recovery and finally a deeper sell-off in the EUR/USD.  

Source: DealBook 360

How Has the Economy Changed Since Last FOMC Meeting (January 27)?

These are the changes that the Fed made to the January monetary policy statement

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Comments (2)

yen-jan

March 15, 2010 at 03:29 PM ET

I agree that the Fed is likely to cautiously upgrade their assessment of the economy.

In addition, there has been much discussion (in Bernanke's testimony and the FOMC minutes) about making the Interest rate On Excess Reserves (IOER) rather than the Fed Funds rate the primary policy rate. This idea has been sufficiently telegraphed to the markets that the Fed could announce this change tomorrow, while keeping the "extended period" language intact. The difference would be that the "extended period" would now apply to the IOER rather than the Fed Funds rate. This change would put in place the machinery for the Fed to start withdrawing liquidity when they judge the timing to be right, while continuing to maintain the IOER at .25% for an "extended period". Once the Fed decides to start withdrawing liquidity (at a later meeting), the Fed Funds rate could drift up into the "corridor" between the IEOR (.25%) and the discount rate (.75%), without a formal change to the policy rates. (See footnote 9 to Bernanke's Feb. 10th written testimony to Congress.)

This is just a guess, but if it happens, then a big move in shorter-term interest rate futures could develop, with significant implications for the dollar.

EMA

March 15, 2010 at 03:55 PM ET

Excellent Analysis Kathy. I also agree with the commentary by "Yen - Jan" on the IOER statement and the phrase "extended period"

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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.