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Fed Comes Up Short, Dollar Soars

Last updated 9/21/2011 3:18 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

Investors are disappointed by the Federal Reserve’s feeble attempt to revive the U.S. economy.  This afternoon, the U.S. central bank took the rare step of twisting the yield curve by selling short term Treasuries and purchasing longer term ones.  This was exactly what the market had anticipated and meeting expectations was just not enough.  The Fed did the minimum of what investors expected and they have been punished for it. Currencies and equities sold off across the board as investors piled back into long dollar positions. The central bank had the opportunity to invigorate the markets but they opted to be extremely conservative which shows just how ineffective they have become. They could have combined Operation Twist with a reduction in the interest rate on reserves or announce a new asset purchase program, but they opted for the cheapest and weakest option next to doing nothing. By buying and selling the exact same amount of Treasuries, the balance sheet remains unchanged which means no additional money was pumped into the U.S. economy. Part of the reason why they were so conservative was because they are holding onto the blind hope that this will be enough to jumpstart the U.S. economy.  Even though the Fed acknowledged the significant downside risks to the economic outlook, they also expect a pickup in the recovery in the coming quarters which is an upgrade from their prior assessment for a somewhat slower pace of recovery.  However investors clearly do not share the central bank’s rosy sentiment.

For those of our readers that caught our FOMC Preview, we listed the reasons why more stimulus may not be so bad for the U.S. dollar and the sharp rally in the greenback post FOMC shows that the disappointment in the Fed is a greater driver of investment flows than the stimulus itself. Investors are losing confidence in the central bank because they keep on coming up short.  They are now buying back dollars and positioning for a prolonged period of slower global growth. Without an aggressive dose of stimulus, the global economy is in big trouble because monetary policy will not be able to offset fiscal austerity. In other words, the sell-off in risk reflects renewed concerns and fear about the outlook for the global economy. 

In terms of the details, the Federal Reserve put Operation Twist into effect today by announcing plans to sell $400 billion worth of short term Treasuries (up to 3 years in Maturity) and use those funds to purchase an equal amount of long term Treasuries (between 6 and 30 years). They will also be reinvesting principal payments from their holdings of agency debt and mortgaged backed securities and will continue to rollover maturing Treasury securities. There was absolutely no talk of additional asset purchases which is encouraging for dollar bulls and discouraging for anyone hoping for more action from the Fed. By not mentioning QE3, it definitely appears that the central bank is saving their few remaining bullets in case the volatility in the financial markets intensifies or the U.S. economy falls into recession. Also, with three FOMC members opposing the move, the central bank may not have had the support that they need for a bolder move. 

At the end of the day, the most important question to ask ourselves is whether Operation Twist will be enough revive the U.S. economy. It could prevent a recession, but engineering growth is a far greater challenge that may require more than a twist of the yield curve.  Keeping yields low has done little to stimulate growth and the Fed’s attempt to drive long term rates even lower may end up being another exercise in failure that will force them to bite bullet and announce QE3. The problem for the U.S. economy is that corporate America is sitting on their cash and not spending it. By twisting the yield curve, the Fed hopes that lower rates will encourage corporate spending and invigorate the housing market, but the biggest roadblock to spending is not borrowing costs, but confidence. We saw this with President Obama’s latest jobs plan – even though many companies welcomed it, they said it won’t change their hiring plans.  Corporations won’t go on a hiring or spending spree until consumer spending increases, the stock market stabilizes and the economy gains some momentum. Lower yields will help but only in a very small way. 

Here is a comparison of the two most recent FOMC statements

Comparing the FOMC Statements

Release Date: August 9, 2011

For immediate release

Information received since the Federal Open Market Committee met in June indicates that economic growth so far this year has been considerably slower than the Committee had expected.  Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up.  Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed.  However, business investment in equipment and software continues to expand.  Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity.  Inflation picked up earlier in the year, mainly reflecting higher prices for some commodities and imported goods, as well as the supply chain disruptions.  More recently, inflation has moderated as prices of energy and some commodities have declined from their earlier peaks.  Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.  The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.  Moreover, downside risks to the economic outlook have increased. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.  However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.  The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.  The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.  The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability.  It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an 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.