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Janet Yellen has initiated the final stage of dismantling the post-GFC monetary policy framework before she (perhaps) departs from her role. The symbolism may be more important than the details. The much-anticipated announcement of the start of balance sheet ‘normalization’ is a statement that the US economy is back to ‘normal-ish’. Through the myopic eyes of the foreign exchange market, this Fed move may:
1) Persuade markets that a December rate hike is a ‘done deal’ if asset markets react positively, while
2) Reinforcing the view that ultimately, peak Fed Funds will come in at 2-2.5%, rather than the near-3% peak the Fed ‘dot-plot’ implies, and
3) Give the dollar some support for now, without really changing the fact that a low peak in rates and a relatively calm global economic outlook support emerging market and higher yielding currencies.
What matters to the FX market is still terminal rather than end-year Fed Funds Embarking on Fed balance sheet reduction is a step into the unknown, albeit one mitigated by the initial steps being very tentative.
It is found one issue that does put the expectations of Fed steps slightly into perspective. USD appreciation following the Fed meeting was mainly due to the fact that the Fed did not change its own forecast, the so called dots (or did so only marginally). Every FOMC member gives their view of where the key rate should stand at a particular point in time (in this case in late 2018) independent of the other members. The public usually looks at the median.
The current dots show a majority supporting four further rate hikes until year-end 2018. The media sources at this juncture interpreted the change in dots as marginal yesterday. The FX market too initially showed a reaction suggesting the Fed had not changed anything. But in reality that is not true. The above chart shows the development of the dots. And a first glance suggests that really not much has changed. But in fact 10 out of the 16 FOMC members must have adjusted their rate expectations by one step to the downside for the June dots to have become the September dots.
The 0.6% rebound in the dollar index was the largest weekly rally seen this year, and came amid shifts in the dollar backdrop across multiple fronts including improvement in Washington dynamics, some relief from the latest CPI report. This suggest a less uniformly bearish USD environment as yet, but potential for near-term upside catalysts for the dollar is tenuous at best.
The USD maintained largely lower against other major counterparts for today as rigidities between the U.S. and North Korea weighing on market sentiment.
