Don't Count On USD Rising Post FOMC

One of the most important jobs of a central bank is to minimize the volatility in the financial markets. Knowing that investors have waited with bated breath for this month's FOMC meeting, team Bernanke know that if they fail to manage the market's expectations properly, they risk triggering a sharp rise in volatility across the financial markets that could end up threatening the overall recovery. 24 hours before the FOMC announcement, U.S. 10-year yields are trading less than 15bp from 3%. Three percent yields is not the end of the world but the central bank would much rather this level be reached gradually than suddenly. The mere talk of tapering has already sent 10-year yields up a full percentage point and this move was a shock to policymakers around the world. As a result, if the Fed reduces asset purchases Wednesday like we expect and they want to minimize the reaction, they will need to communicate clearly that tapering does not equal tightening and they stand ready to step up bond purchases again if the economy weakens.

The Fed has put themselves into a very difficult position. While many economic reports have deteriorated since the July meeting, back in June Bernanke said the central bank will stop buying bonds and mortgage backed securities if the unemployment rate falls to 7%. The current level of unemployment is 7.3% and if the Fed were to end QE at 7%, they will need to start curbing their monthly bond purchases now. A reduction in Quantitative Easing should be positive for the dollar but investors can't assume that the dollar will automatically rally post FOMC. Strategically, the Fed will most likely strive to underwhelm, with the hopes of limiting any rise in yields, collapse in stocks and rally in the U.S. dollar. There are a few ways they can manage down expectations:

How the Fed Could Manage Down Expectations

1. Reduce asset purchases by $5 billion to $10 billion per month instead of $15 billion to $20 billion per month
2. Cut Treasury purchases but leave MBS purchases intact to support the housing market
3. Lower GDP and inflation forecasts (2016 forecasts will be unveiled)
4. Reinforce forward guidance by saying that tapering does not increase the chance of tightening
5. Express commitment to step up bond purchases if economy weakens

Knowing the risk that taper could have on long term bond yields, we expect the Fed to choose all of the above which could adequately stave off an unfavorable reaction in the financial markets. Downplaying a decision to taper could also drive the U.S. dollar lower, which the central bank would be happy to see since a weaker currency supports the economy. A less likely but still viable option would be to delay the decision to December and if the Fed chooses to do so, we expect the dollar to sell-off quickly and aggressively. In terms of timing, the Fed's decision on tapering and their latest economic projections will be released at 2:00pm ET/18 GMT. This will be followed by a press conference with Fed Chairman Ben Bernanke at 2:30pm ET/18:30 GMT.

GBP: Will BoE Minutes Contain A More Optimistic Tone? The British pound is holding at a six-month high against the euro and U.S. dollar ahead of the FOMC rate decision. The focus of the market may be on the Fed meeting, but sterling traders should not overlook Wednesday's release of the Bank of England minutes. We are eager to see if policymakers have grown less dovish after the recent improvements in economic data. We have good reasons to believe that the minutes will be slightly more optimistic because last week Bank of England Governor Carney, MPC members Miles, Fisher and McCafferty all acknowledged the recent improvements in the economy in their speeches, with some even going so far as to say that the recovery has gained momentum. Yet every MPC official also expressed hesitations that ranged from the recovery being very new to the elevated risks facing the economy. So while the central bank on balance has grown more optimistic, Carney made it very clear that they would not change the level of Quantitative Easing until the unemployment rate falls to 7%. When that occurs, the central bank could be prepared to raise interest rates because "BoE tightening will begin with rate increase." What is interesting is that while he said additional stimulus is possible if the economy needs it, he also added later on that they have "no problem with raising rates if needed." The BoE believes the 7% level will be reached in 2016 but the market is pricing in tightening in January 2015. According to this morning's CPI report, inflationary pressures edged lower, giving the central bank the flexibility to keep monetary policy easy. Wednesday's BoE minutes could harden or reshape those expectations and affect the GBP/USD's chances of breaking 1.60.

EUR: Strongest Investor Confidence In 3 Years
The euro traded slightly higher against the U.S. dollar on the back of a stronger investor confidence. The ZEW survey jumped to 49.6 in the month of September from 42.0 in August. Despite the recent deterioration in data and political / geopolitical uncertainty, the expectations and current situations component of the ZEW survey surged as confidence reached its highest level in three years. Investors are optimistic that stronger growth in the U.S. and China will support the German and euro-zone economies. The ZEW survey was the only piece of good news as the current account and trade surpluses for the region narrowed in the month of July. Admittedly most of the weakness in data that we have seen from Europe has been for the months of July and August -- perhaps the momentum accelerated in September. Well get a better sense of whether this has occurred next week when the September PMI reports are released. Since the ZEW was the most important euro-zone release on the calendar this week, the near term price action and outlook for EUR/USD should be driven entirely by the market's appetite for U.S. dollars.

AUD Shrugs Off RBA Minutes
U.S. dollar weakness continued to drive the Australian, New Zealand and Canadian dollars higher. The biggest gains were seen in the NZD, which rose to its strongest level against the AUD since May. No major economic reports were released from New Zealand or Canada but the Reserve Bank of Australia released its monetary policy minutes. Although the central bank refrained from saying there was "scope to ease policy further" at their last meeting, the minutes revealed that the RBA felt "the Bank should again neither close off the possibility of reducing rates further nor signal an imminent intention to reduce them." While investors rightfully interpret this comment to mean that the door to further rate cuts is not closed, the AUD/USD shrugged off the news during the European trading session and extended its gains in North America. New Zealand's current account report and Australian leading indicators were the only pieces of data expected from the commodity producing countries Tuesday evening and while they could cause a small blip in the currency, the key driver of price action will be the FOMC rate decision.

JPY: Data Shows Strong Demand For USD In July
The Japanese Yen traded lower against all of the major currencies Tuesday as equities edged higher ahead of the Federal Reserve's monetary policy announcement. No economic data was released from Japan but the U.S. Treasury's International Capital Flow report showed that Japanese investors were the biggest buyers of U.S. bonds in the month of July. In fact if not for the demand from Japan, foreign investors would have been net sellers of U.S. Treasuries that month. Lured in by rising U.S. yields, Japanese investors bought $55.1 billion in July after selling $51.5 billion in June. This data is consistent with last week's Ministry of Finance's report that revealed the first positive month for U.S. bond purchases in Japan since the beginning of the year. While these numbers are interesting, much of this flow could have been reversed in August because the weekly MoF data has shown Japanese investors selling foreign bonds in size that month.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.