Fed Deeply-In-Dove, SEK Rallies On Data

Forex News and Events:

The dovish FOMC minutes hit US yields and USD in New York yesterday, as the FX markets adjusted positions. Although the recent improvement in the US labor market boosted the Fed hawks, FOMC Chair Yellen’s flexibility for action remains quite limited given the deep expansive conditions surrounding the Fed. We will zoom into academic studies to find out how far the Fed has gone. In Sweden, the June inflation readings surprised on the upside; the markets ask whether the Riksbank acted too aggressive at July meeting. In UK, the BoE will give policy verdict at 11:00 GMT and is expected to keep the status quo.

Was Riksbank action exaggerated?

Sweden posted better-than-expected inflation figures in June, the CPI m/m accelerated at the pace of 0.2%, pulling up the yearly CPI to 0.2% (highest since November 2012). In addition, the unemployment also deteriorated less-than-expected over the same month (4.1% in June vs. 4.3% exp. & 3.9% last). Only one week after Riksbank cut its bank rate from 0.75% to 0.25 mostly due to soft underlying inflation dynamics, markets already question whether the recent 50 bp cut was too excessive.

Combined to USD weakness, USD/SEK retreated to 6.7610 in Stockholm. Light option bids are eyed at 6.7600 for today expiry. While the bullish momentum slowly vanishes, the overall bias remains positive. Short-term support is seen at 21-dma (6.7260), then 6.6925 (Mar-Jul uptrend channel base). The key support stands at the distant 6.6763 (Fib 61.8% projection on 2012-2013 drop). NOK/SEK rallied on stops after clearing support at 1.1000/05 (psychological level / 21-dma). The downside rally halted above 100-dma as Norway posted acceptable inflation data. Option bets are mixed at 1.1000 levels, the key support is eyed at 1.0841 (July 2^nd low).

Wu & Xia’s shadow rate suggest little Fed flexibility

A recent study by Wu & Xia gains traction in discussions on Fed and its extra-lose zero-rate policy augmented by unprecedented unconventional measures. The study is the extension of Fisher-Black (1995), which first suggested that zero percent is not the lower limit for nominal interest rates. Beyond the observed Fed Fund rate, the markets should evaluate the “shadow FF rate”, which can be explained as the difference between the nominal rate and the value of a call option on cash with zero percent return. Xia and Wu estimate the shadow rate at -3.0% in 2014.

St Louis Fed President Bullard had asked “Is current US monetary policy “too easy”?” on November 2012 in Washington University. At that time already, the answer was yes. Today, it seems to be a deeper yes. Almost after two years, the Fed policy remains too expansive still and part of Fed members think this way; indeed the Fed dots settled a steeper policy path in June 17-18^th meeting. However the FOMC minutes showed that the participants are not fully convinced on US recovery strength to start talking about a proper tightening yet. Minutes showed that US policy makers agreed to end the asset purchases program by October, yet also to keep the favorable financial conditions to sustain recovery. Some policy makers were concerned about the low inflation in Euro-zone and Japan that may damage the US inflation outlook. Fed participants continue anticipating the US inflation below 2.0% over years ahead. Many of them sounded in favor of keeping the wide spread (20-30 bp) between interest rates on excess reserves (IOER) and reverse repo rate (RRP). Indeed, as long as there is enough liquidity in the markets, the IOER will be an efficient ceiling to short-term rates, while the RRP stands for lower band. Now, as banks has access to both tools while other financial institutions only use RRP, a higher IOER will continue pushing the liquidity towards banks, in hope to see this liquidity transmitted to real economy.

This said, the critical question is still not answered: when will the Fed start normalizing?

Markets will keep seeking the answer in the US economic data. After the recent meaningful improvement in US unemployment rate (6.1% in June) and the successive good NFP readings, economists revised their expectations in favor of sooner start of Fed normalization (the most aggressive players are already betting for the first Fed hike in Q1). Nonetheless, despite supportive labor data, the Fed should make sure that the economic recovery is well anchored, some officials are well aware of the restricted flexibility the Fed has in dealing with new potential financial shocks. With the nominal rate at the zero lower bound and the inflation already above 2.0%, we cannot expect any hawkish surprise from Yellen-the-dove nor her policy-mates.

Today's Key Issues (time in GMT):