Filled With Dread

The conundrum that’s facing the Fed

Is joblessness is flashing red

But prices won’t rise

Despite all their tries

Thus rate hikes have them filled with dread


With Thanksgiving nearly upon us, the one truism we will see today is that market activity in the US is likely to be extremely quiet. Despite the fact that we will be getting a concentrated dose of data, the reality is that probably half of the market has already gone on holiday and will not be concerned until next Monday when they return. It is with this in mind that a discussion of the FOMC Minutes, to be released this afternoon at 2:00, needs to be taken.

If you recall back to November 1st when the Fed met, the outcome was no change in rates, and an upgrade of the description of the economy to rising at a “solid rate” from “moderately”. They passed off any impacts of the hurricanes as temporary and penciled in a rate hike for December. It is hard to believe that the data and comments we have received since then have changed that view substantially. Perhaps the one issue is that the continued slow rise in measured inflation may result in a few of the more dovish FOMC members (Kashkari, Brainerd) dissenting from the vote to raise rates next month. But from our perspective, the important question is what can they do to impact the dollar?

While I have stopped posting the rate hike probabilities, they are still out there, and this morning the market has priced in a 100% chance that the Fed will raise rates by 25bps in three weeks’ time. This means that if (when) they do raise rates, any market reaction is likely to be quite muted. I guess if several members do dissent then the dollar could suffer somewhat as traders would start to price in the chance that the Fed will be less active next year. Arguably, though, this is exactly what the Fed wants, no market response to their actions. On the flip side, if they leave rates unchanged, I would expect to see the dollar come under instant pressure, with a sharp rally in the bond market and arguably a sell-off in stocks as well. The key question then would be, ‘what do they know that we don’t about the economy that would cause them to change their view?’ And the implication would be there was some problem that would have a negative impact. Now I don’t expect this to be the case and fully well anticipate them to raise rates as they have promised.

Which brings me to the second point I’d like to make, does the Fed (or any of the central banks for that matter) continue to drive the currency market in the short term? This is a much tougher question to answer. On the one hand, market participants are keenly aware of every utterance made by a member of this august group of policymakers. But one need only look at the complete lack of volatility evident in markets to question just how much direct impact they have, or at least the magnitude of any impact. I might argue that the FX markets have moved on from following short-term rate differentials to being more visibly impacted by relative long-term interest rates.   So if the 10-year Treasury yield rises to a more than 250bp differential to that of JGB’s or Bunds, then we are going to see investment flows turn more aggressively toward the dollar to earn that extra yield. Meanwhile, relative changes in the shorter dated yields seem to be having a smaller impact. Now I know that the central banks had been having a direct impact on bond yields via QE, but as those policies change, and remember the Fed is already starting to shrink its balance sheet while the ECB slows its pace of buying, I expect that the central banks are going to find themselves with less direct impact on FX.

Personally, I think this is a very positive outcome, but I wonder how happy they will be if they figure out they have ceded control of one corner of the market to investors and traders rather than their own brilliance. In fact, they may have put themselves in a position where the only impact they have on markets is by surprising traders with unexpected actions, rather than by trying to simply affect the policies they believe are appropriate. And history shows us that surprising markets is not the best long run solution to manage the economy. FWIW, this is a direct result of their policy of forward guidance, which resulted in almost every investor and trader being positioned in the same direction. I fear the central banks have painted themselves into a proverbial corner and have reduced their own set of tools needed to address policy concerns. This also puts a premium on insuring that they make ‘correct’ policy decisions, because mistakes can snowball quickly. Consider if inflation started to show up more aggressively and the market determined the Fed was behind the curve. That would not be a pretty outcome for investors! Food for thought.

At any rate, once again today’s markets have been mixed, although I would characterize the dollar as slightly softer overall. But the reality is that overall activity remains light ahead of the holiday. We get a bunch of data this morning as follows: Initial Claims (exp 240K); Durable Goods (0.3%, 0.5% ex transport); Consumer Confidence (-0.8) and Michigan Sentiment (98.0). It seems hard to believe that in this market environment any of those will drive markets. With equity markets making new highs again, there continues to be a sense of complacency that is unlikely to change in the short run. As such, I expect the dollar to remain range bound for now, although as it consolidates its recent gains from the September lows, I still expect the next leg to be somewhat higher.

Good luck and have a great holiday. FX Poetry will be back on Monday.