Today is the first day of the Federal Reserve's 2-day December monetary policy meeting and the consolidation in currencies show that investors are waiting with bated breath for the FOMC announcement. Over the past week, the dollar appreciated against many of the major currencies but the gains have been small. Since the surprisingly strong labor market numbers, the dollar strengthened against the AUD, GBP and NZD but weakened against the EUR, JPY, CAD and CHF. This price action reflects the level of uncertainty and lack of conviction for the central bank's actions this month. Even 10-year Treasury yields have flat lined and the fact that yields remain below their September highs suggests that the bond market has not fully priced in tapering.
With USD/JPY and the EUR/USD hovering right below multi-year highs, the big question on everyone's minds is which direction these pairs will move after Wednesday's FOMC announcement. We have seen USD/JPY and EUR/USD rise simultaneously when stocks responded positively to the non-farm payrolls report but the FOMC announcement is significant enough that we could also see a uniform reaction in the dollar. It all boils down to how clearly Ben Bernanke lays out its plans for ending Quantitative Easing before he leaves office. While it may be exciting for the outgoing Fed Chairman to outline his vision for ending a program he started in 2008, he won't be the one that has to deal with the consequences of withdrawing stimulus too slowly or quickly. It is important to remember that when it comes to the FOMC decision, one of the top priorities of the central bank is minimize the volatility from their announcement. This is why the Federal Reserve introduced a press conference - they want to be able to explain their decision and manage expectations. Therefore the press conference this month will be just as important as the decision on tapering.
Here are the 4 possible scenarios for tomorrow's announcement and the potential impact on the dollar.
- Scenario #1 - No Taper, No Guidance, Decision Pushed to 2014
If the Fed refrains from tapering, keeps their asset purchase program unchanged and simply says they are watching incoming data, the dollar will fall aggressively against the euro and Japanese Yen. By standing down completely and providing zero forward guidance, Bernanke would effectively be telling us that he is relegating the decision to his successor. The market would expect Janet Yellen, who is one of the most dovish members of the FOMC to prolong Quantitative Easing and delay tapering. Based on the price action in currencies and Treasuries, investors have priced in tapering in December or January, so if there is reason to believe that it will delayed to March or April, they will need to adjust their positions accordingly which would mean a sell-off in the dollar, rise in U.S. stocks and decline in yields.
- Scenario #2 - No Taper, Signals Plan to Reduce Purchases in Early 2014
Mildly Bearish USD (-USD/JPY, +EUR/USD)
The Fed could also refrain from tapering but strongly signal plans to reduce purchases in early 2014, which would mean either January or March. This is actually one of the highest probability scenarios supported by many economists who think Bernanke won't risk halting the Santa Claus rally. While there have been broad based improvements in the labor market and consumer spending, this morning's consumer price report shows that inflation is low giving policymakers the option to wait because inflation is not a major risk. The housing market has also been mixed but more importantly, stronger manufacturing activity is offset by slower growth in the service sector. U.S. yields have increased significantly over the past 7 weeks and by tapering, the central bank risks driving 10-year yields to 3%. We expect the dollar to sell-off initially when the FOMC announcement is made but depending on the strength of the forward guidance provided by Bernanke, the dollar could end up recovering part or all of its initial losses
- Scenario #3 - Taper $5 - $10B, No Guidance
Mildly Bullish USD (+USD/JPY, -EUR/USD)
Our base case scenario is for a small amount of tapering this month ($5 to $10 billion) followed by a noncommittal outlook for further reductions that would minimize the market's reaction and give Janet Yellen the flexibility to design her own strategy for unwinding stimulus. For the Federal Reserve, the greatest motivation for December tapering is the strength of U.S. data. Since the last FOMC meeting, we have seen a significant recovery in consumer spending and the labor market. Non-farm payrolls have averaged 204k over the past 4 months and this strength drove the unemployment rate down to 7%. Retail sales rebounded in November after contracting in September and according to the latest consumer sentiment survey, Americans are feeling more optimistic. Considering that it is only a matter of time before the Fed starts reducing its monthly bond buys, it may be strategically sensible to begin tapering this month so they can spread the reductions over a longer period of time. Tapering by a small amount and saying that further reductions would be data dependent could be one of the most palatable options for the Fed. It would allow Bernanke to begin the process of unwinding stimulus but leave Yellen with the flexibility to adjust the program as she sees fit. It would also limit the reaction in equities and currencies, allowing for a more moderate rally in the dollar and sell-off in stocks.
- Scenario #4 - Taper $15B - $20B, Strong Forward Guidance
Bullish USD (+USD/JPY, -EUR/USD)
If the Federal Reserve tapers in December and lays out a clear plan to reduce asset purchases over the next few months, we expect the dollar to soar and equities to fall quickly and aggressively. Committing the central bank to a detailed plan would be decision that needs Yellen's consent that would suggest the incoming Fed Chairwomen is onboard with reducing asset purchases immediately. This is the lowest probability scenario but an option that would be extremely positive for the dollar and U.S. yields but negative for stocks.
Tomorrow's decision will be a very close one as strong arguments can be made for and against December tapering. Looking beyond the initial reduction in asset purchases, the real question will be quickly the central bank ends QE. Originally the Fed had planned to begin reducing its monthly bond buying in the third quarter of 2013 and end the program by mid-2014. Its now December and its not even clear whether the central bank will slow purchases this month which means there is a good chance QE may not end until 2015. The pace at which bond purchases will be halted next year will determine how much upside there is for the dollar next year.
Kathy Lien, Managing Director of FX Strategy for BK Asset Management.