By Kathy Lien, Managing Director of FX Strategy for BK Asset Management
Wednesday's hawkish FOMC statement breathed new life into the U.S. dollar and, looking ahead, we anticipate further gains in the greenback. From their pre-FOMC levels, the EUR/USD dropped more than 100 points while USD/JPY soared by approximately the same amount. Before the end of next week, we expect EUR/USD to test and break its 2-year low of 1.25 and USD/JPY to test 110.
Going into Wednesday's meeting, the Fed was widely expected to end Quantitative Easing but barely anyone anticipated such a significant upgrade to its labor-market assessment. In fact, the dollar traded lower ahead of the decision because most market participants were looking for the central bank to express concern about falling inflation expectations, which would have been bearish for the greenback. While the Fed acknowledged the recent decline in price pressures, it viewed it as temporary and instead spent most of the statement talking about the uptick in jobs.
Our Main Takeaways From The Federal Reserve's Policy Announcement:
- Fed remains on track to raise rates in mid 2015
- The "considerable time" language will most likely be dropped / changed next month
- They can no longer turn a blind eye to the improvements in the labor market
- They view the decline in price pressures as temporary
- They are not worried about the slowdown in global growth
- Kocherlakota dissents but Plosser and Fisher voted for today's actions
Clear Vote Of Confidence
The Fed's statement is clearly a vote a confidence for the economy because not only did the Fed fail to share the market's concern about low inflation but it went one step further by upgrading its assessment of the labor market. The Fed no longer sees "significant" underutilization of labor-market resources and instead acknowledged the improvements including solid job gains and a lower unemployment rate. In addition, there was no mention of the slowdown in global growth hitting the U.S. economy.
Although the Fed could have waited until December to sound more upbeat about jobs, there's a good chance policymakers wanted to take advantage of the recent decline in rates. The Fed did an excellent job of smoothing the market's reaction to the end of QE by outlining its protocol well in advance and now it is doing the same by slowly upgrading its assessment and preparing the market for a rate hike next year. While the Fed preserved the "considerable time" language in the FOMC statement this month, come December, that line could be dropped as well.
Reset Rate-Hike Expectations
Looking ahead, the trade in the FX market still centers around policy differentials. Wednesday's decision resets expectations for a mid 2015 rate hike by the Fed. In contrast, more easing is expected from the Bank of Japan and the European Central Bank. Later Wednesday evening, the BoJ was widely expected to admit that it will take longer to reach its inflation target, which should lead to further weakness in the yen. While we have been looking for long-term dollar strength for some time, we are now also looking for short-term gains, all of which plays into our new calls for 1.24 EUR/USD and 110 USD/JPY.