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Traders Wait on the FOMC

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Weak Durable Goods Orders caused a brief rally in risk assets last night, with both the Core and Non-Core figure missing expectations at -0.2% vs. 0.5% and -1.3% vs. 0.4% respectively. Most USD pairs rallied on the news with EUR, GBP, AUD and NZD all gaining half a cent against the US Dollar. This data point is the last of significance before the FOMC statement and monetary policy decision tonight.

Following the FOMC statement (21:00 server time), the BEA will release US Advance GDP on Thursday (15:30 server time). Analysts expect a strong figure of 3.1%, which is slightly down from the previous result of 4.6% – a number which was strongly influenced by a rebound from the first quarter’s weather induced negative growth. If the Federal Reserve proceeds with its expected stimulus withdrawal, there will be added pressure for a good number to justify the central bank’s move. Chair Yellen may also take the opportunity to discuss the statement in her speech in Washington (16:00 server time Thursday).

Immediately following the FOMC statement, the RBNZ will decide on the New Zealand overnight interest rate. No change is expected at this meeting, with inflation at a manageable level and house prices under control through macro prudential regulation. Economists expect the RBNZ to continue with the phrase “it is prudent to undertake a period of monitoring and assessment before considering further policy adjustment”, however it is possible that the bank alters the phrase “Nevertheless, we expect some further policy tightening will be necessary to keep future average inflation near the 2 percent target mid-point and ensure that the economic expansion can be sustained.” to reflect recent fundamentals.

The FOMC Statement:

What is happening: Today the Federal Reserve will release its monetary policy statement. The Federal Open Market Committee will provide their monetary policy decisions along with a statement explaining them and forecasts on the future path of interest rates.

What is expected: Up until recently, the Federal Reserve’s latest round of Quantitative Easing was almost unanimously expected to conclude by reducing the purchased amount by 10 Billion per month, with the final amount to be reduced by 15 Billion at the end of this month. This is still the most widely expected outcome by analysts and economists, with only a minority expecting some change to this path of normalization.

What are the rumours: Volatility across markets in October has led some to call for the central bank to extend its purchase program out to December, in order to settle markets; these calls have been amplified by global inflation trending lower and Oil price declines pushing inflation expectations below central bank targets. Inflation expectations implied from the spread between inflation protected treasuries and their standard counterparts are falling to levels which have, in the past, implied further easing.

The last FOMC Meeting Minutes, revealed this month, showed that some members were concerned about the pace and scale of the recent gains in the US Dollar against a broad basket of other currencies, though in particular the Euro. These concerns were expressed prior to the EURUSD exchange rate falling a further four cents, so they may have increased in the month that followed. Some important sections of the minutes caused a sell-off in the US Dollar after its strong rally:

“The staff’s medium-term forecast for real GDP was also revised down a little, reflecting a higher projected path for the foreign exchange value of the dollar…”

“Over the intermeeting period, the foreign exchange value of the dollar had appreciated, particularly against the euro, the yen, and the pound sterling. Some participants expressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector. Several participants added that slower economic growth in China or Japan or unanticipated events in the Middle East or Ukraine might pose a similar risk. At the same time, a couple of participants pointed out that the appreciation of the dollar might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal.”

The Federal Reserve has a dual mandate to ensure maximum employment and stable prices. The first part of this mandate is being fulfilled gradually as the unemployment rate continues to decrease steadily towards a level consistent with the long term natural rate of unemployment.

The second part of the mandate is what has caused some to speculate that the Fed will reverse course; inflation remains around 1.5% by various measures while the Federal Reserve targets inflation of 2%. Should the Federal Reserve decide to change its course, market volatility could be quite extreme as US Dollar positioning is currently near record levels in anticipation.

This is a notion supported by FOMC member John Williams:

“If we really get a sustained, disinflationary forecast … then I think moving back to additional asset purchases in a situation like that should be something we should seriously consider,”

Another possibility is that the FOMC members alter their expectations for the future path of interest rates; this is likely to have a smaller impact on markets than changing course on Quantitative Easing, however it may be a more likely possibility. FOMC members, at the last meeting, increased their expectations for the Fed Funds rate next year, implying a fairly strong tightening cycle over the course of 2015 of over 100 basis points or 1%. Given the movements in markets since the last meeting, it would not be surprising to see the forecasts take a step backwards.

The FOMC’s longer run forecasts are ironically – or ominously – now forming a downwards pointing arrow despite recent upwards adjustments:

Changes to the statement are another source of uncertainty. Much focus has fallen upon the use of ‘Considerable time’ as an indicator of how long after QE ends the market should expect rate increases. There has been discussion in the minutes about moving this wording to reflect that the decision will be ‘data dependent’, rather than on a set time-frame. It is not clear exactly how the market would react to such a change, but it would likely cause some volatility.

Why it is Important: This month’s statement has a high chance of seeing, at least temporarily, the end of the US Federal Reserve’s experience with unconventional monetary policy in the form of asset purchases. Since the GFC recovery began over 5 years ago, markets have only experienced a world without QE for a little over eight months all up, with the remainder of the time spent under the sequence of QE1, QE2, Operation Twist, QE3 and the QE3 expansion.

Both periods without QE saw significant market corrections in equities, with US long term bonds rallying sharply under the uncertainty that followed. FX markets have been similarly affected, with risk currencies rallying under the asset purchase programs. Traders have already priced in some of the risk, however it is yet to be seen whether this US Dollar strength continues in to a long-term bull market or whether the Federal Reserve panics and backs down by re-opening the liquidity floodgates.

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