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FOMC Preview: What to Expect from the Fed and the Dollar

Last updated 11/1/2011 12:30 PM ET (GMT -5) 1 Comments

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Kathy Lien

Director of Currency Research, GFT

By Kathy Lien, Director of Currency Research at GFT

Investors are flocking back into the safety of U.S. dollars but their appetite for the greenback could change if the Federal Reserve introduces a new round of stimulus this week.  The volatility in the markets pushed the Reserve Bank of Australia to lower interest rates last night and the Federal Reserve could be spooked into similar action.  Of course there is no room to move on rates in the U.S., but the Federal Reserve could increase the size of their asset purchase program or change their communications strategy.  Recent comments from Fed officials suggest that they are warming to the idea of more stimulus but their next move could be another middle of the road approach as they reserve QE3 for a time when the markets are down 20 and not 5 percent.   The Federal Reserve will most likely change their communications strategy but even then there are a few different options and the impact on the dollar will depend on how transparent their change is.

Armed with a non-farm payrolls report that showed zero job growth back in September, the Federal Reserve launched Operation Twist in an attempt to revive the U.S. economy.  Fast forward 6 weeks from their last monetary policy meeting and there have been mild improvements in the U.S. economy.  Non-farm payrolls rebounded in October and the September report was revised higher, showing an addition of 57k jobs instead of the zero job growth that was initially reported. Retail sales also rose 1.1 percent while stocks recovered from its early October lows.  Despite these improvements however, Operation Twist cannot be deemed a true success which is why the Federal Reserve is expected to do more. Not only was there continued deterioration in the manufacturing and housing sectors but yields have barely budged since the September announcement.  The goal of OT was to drive down long term yields, but after a very brief dip to 1.72 percent, the 10 year Treasury yield rose back to 2.00 percent.   A similar movement was seen in the 30 year mortgage rate which fell from 3.645 to 3.327 percent days after the FOMC announcement but settled back at 3.673 percent on Monday.  According to central bank officials such as Federal Reserve Vice Chair Janet Yellen, further asset purchases could occur “if evolving economic conditions called for significantly greater monetary accommodation.”   There has not been enough deterioration to warrant a change in policy but the tone of the global financial markets has taken a turn for the worse.

Fed’s Options for Changing Communication Policy and Impact on U.S. Dollar

When it comes to changing their communication policy, the Fed has a few options:

1.   Release Economic Forecasts and Forecasts for Fed Policy

2.  Set Inflation Target

3.  Pledge to Keep Rates Low Until Unemployment Falls below a Certain Rate

There is a great deal of urgency within the central bank to increase transparency on monetary policy but it is a challenge to establish and agree on specific targets and could cause confusion about the central bank’s longer term objectives.  Nonetheless, this approach is still the Fed’s preferred option over expanding the balance sheet. The central bank has already pledged to keep interest rates at exceptionally low levels through mid 2013.  If they choose to extend this period, which would be a new forecast for Fed policy, it would hurt the dollar but probably not as much as a target for inflation or the unemployment rate.  A more aggressive approach would be the one that Chicago Fed President Evans has suggested which is to officially say that rates will remain at extremely low levels until the unemployment rate falls below 7 percent or inflation rises above 3 percent.  Explicit unemployment and inflation targets would be almost as bearish for the U.S. dollar as QE3.  The Fed could also bite the bullet and expand their balance sheet (QE3) which would send the greenback sharply lower but the chance of it happening this week is slim.

The FOMC announcement will be made at 12:30pm ET and this will be followed by a press conference by Bernanke at 2:15pm ET.  Bernanke will not only explain any changes to monetary policy but also changes to their economic assessment.  There is a very good chance that the central bank will downgrade its GDP forecasts for 2011, 2012 and 2013 which will not go over well with the market.  The scope for a reversal in the U.S. dollar is greater than a rally but the weakness could remain contained in USD/JPY because pessimistic comments from the Fed will probably end up being more negative for risk and the biggest victim will most likely be equities.

Checking in on the U.S. Economy

The following table shows how the U.S. economy has performed since the last monetary policy meeting.  A closer look at the economic releases reveals more improvement than deterioration in the economy.  The health of the consumer, labor market, inflationary pressures, and market indicators all improved while the housing market was unchanged and the manufacturing sector lagged.  Retail sales grew 1.1 percent in September despite deterioration in consumer confidence, after being flat in August.  According to the University of Michigan, consumer sentiment improved slightly to 60.9 in October from 59.4 but the Conference Board reported more pessimism.   The labor market showed some improvement as non-farm payrolls indicated the economy added 103,000 jobs in September compared to 57,000 jobs in August.  The unemployment rate still remains elevated at 9.1 percent, but things are starting to move in the right direction.  Producer prices grew at a healthy rate while consumer prices cooled off a bit. The S&P 500 index has traded higher along with yields.  Recent developments in the housing market have, on the whole, been flat.  The NAHB housing index, housing starts and new home sales improved but existing and pending home sales declined along with building permits which tends to be a leading indicator for the housing market.  The manufacturing sector performed the worst since last month’s monetary policy meeting as growth slowed or contracted in some cases.  The most notable developments were in manufacturing prices and factory orders as they dropped significantly.  Manufacturing prices fell sharply to 41.0 in October, indicating contraction, from 55.5 in September.  This pulled the ISM index of U.S. manufacturing to 50.8 from in October from 51.6 the prior month.  A slowing global economy may be limiting demand for American-made goods, restraining production and the industry that’s paced the two-year-old recovery.  With as much recovery as deterioration, the Federal Reserve has a tough choice to make this month.

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Comments (1)

Darkdoji

November 02, 2011 at 06:43 AM ET

The political ramifications and the need for coordination with fiscal authorities - in using job and inflation targets would warrant significant consultations with government. Such consultations can hardly be kept secret, therefore it does look a slim chance for any radical change in communication strategy given the absence of widespread news/rumors on that score. You have already ruled out any immediate application of QE3 on the idea that the depth of decline in stock markets is not enough at 5%. If you are correct we are left with probable downgrade of growth forecasts, and the expression of pessimistic concerns for US and global growth - which in your estimation will be negative for stocks. My take then is a bearish outcome for risk - consistent with the technical positioning of the unitary trends in various risk units.

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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.