Fed could play a wild card and spark USD rally next week
- The Fed's rate hike is already baked in, so it will have little impact on USD
- Curve flattening is an indicator of a recession
- A recession is on the cards in the US, and perhaps even overdue
- The Federal Reserve's balance sheet is a wild card
By Max McKegg
Next week’s meeting of the Federal Open Market Committee will be the swan song for chair Janet Yellen. A feature of Yellen's term in office has been a “no surprises” policy. If market pricing heading into a rate announcements was giving the wrong signal, well-placed media sources would be briefed to put traders back on track.
A 25 basis point hike is priced as virtually certain, so the Fed will have to pull a rabbit out of its hat to impact forex markets. Photo: Shutterstock
As there have been no leaks to the contrary, a 25 basis point lift to fed funds target range to 1.25%-1.50% is priced as virtually certain, as shown in the following chart of the December fed funds futures contract (click to enlarge). As such, the Federal Reserve would need to pull a rabbit out of its hat to have any impact on FX markets.
Fed funds chart
Even if it wasn’t already fully priced in there’s little reason to believe USD traders will be spurred into action by another move in the Fed’s latest tightening cycle.
As indicated in the chart shown below, rate hikes don’t necessarily mean USD will rise. Neither does a tax cut: both the Reagan and George W Bush tax cuts did nothing to reverse a downward trend in USD. The index remains perched on key support levels waiting for a trigger to move. A rate hike next week won’t be that trigger.
A flattening of the yield curve seems to be the major factor holding the dollar back. As shown in the following chart, short rates on US Treasuries have been on the rise while long rates are holding, at best. The flattening has surprised analysts and, no doubt, Fed officials as well. The curve was expected to steepen as the biggest player in the market started to run down its $2.5 trillion portfolio.
Rates at the short end have been rising because the Fed seems determined to push ahead with its “normalisation” of monetary policy, aiming for what it sees as a neutral rate for fed funds of 2.75% by 2019. The FOMC’s September projections show 75 basis points of rate hikes pencilled in over 2018. Markets have moved in that direction, but begrudgingly, pricing in around 50 basis points.
US curve chart
The Fed wants to move forward with policy normalisation to give itself some room to manoeuvre when the next recession hits. The current expansion in the US is the longest in 50 years and unless “it’s different this time” and the business cycle has been overcome, a recession is on the cards, perhaps overdue. If that’s the case then the Fed might have to stop tightening next year and even reverse course. Suspecting such, traders are reluctant to push long rates up higher.
Yield curve flattening is not isolated to the US. As the following chart shows, it’s flowing through into the Eurozone as well with the yield on 10-year German bunds slipping back under 0.30% while shorter dates become less negative. And the Bank of Japan is having no trouble with its yield-curve-control policy: the yield on 10-year JGBs is holding just above zero.
US and Germany 2 versus 10 chart
So where does this leave the FOMC heading into Wednesday’s policy review meeting?
A rate hike is baked in, so traders’ attention will be directed towards the post-meeting statement and the updated Summary of Economic projections, in particular the “dot plot” path for the fed funds rate. The current situation is shown in the chart below.
Each quarter Committee members submit projections, presented as chart “dots” with a line drawn through the median. In September the median projection for 2018 was for 75 basis points of rate hikes, the same as in in the previous (June) set. But longer term rate forecasts were lowered, an endorsement of the fed funds futures curve which has a more moderate pace of rate increases priced in.
Dot plot chart
This time around, the Committee will want to show the markets an intention to stick with the game plan, that is, to push rates up so as to provide room to move if and when the next recession strikes. As such, hawkish members may incorporate a fourth hike into their 2018 dot.
But moderates will be wary of making any changes at all and, if anything, lowering their projections on the basis that previous assertions low inflation was due to “transitory” factors have proven to be misguided and that “structural” factors are taking hold. It will be too late to take into account but the November Consumer Price Index numbers will be released a few hours before the meeting winds up.
USD traders have learned this year to take more notice of money market pricing rather than FOMC rate projections; pricing right across the curve, not just the short end. So the Committee would have to play a wild card to have much impact on forex markets, something that steepened the curve. And they might want to do just that, given that talk of curve flattening as a recession indicator could become self-fulfilling.
Do they have anything up their sleeve? They sure do: a $2.5 trillion holding of securities. A hint that the portfolio may be run down at a faster rate than previously indicated would be just the trigger needed to spark a USD rally.
– Edited by Robert Ryan
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Max McKegg is managing director of Technical Research Limited. If you would like to receive his Daily FX Trading Forecasts, then you are welcome to contact him (see his contact details under his biography on Trading Floor)