USDJPY closed around 110.86 in the US session Wednesday, surged by almost +0.26% and made the session high of 111.08 on less dovish testimony by Fed’s Chair Powell. USD was also boosted by month-end rebalancing, a sudden plunge in US Treasuries, which may be also technical in nature, coinciding with its translantic peers (German Bunds). The US10Y bond yield made a session high of 2.690%, while the German 10Y Bund yield made a high of 0.168%, off the January low of 2.543% and February low of 0.077% respectively. The market may be also covering USD shorts ahead of the US GDP and core PCE inflation data in the coming days.
Earlier in the Asian session Wednesday, USDJPY under stress on worsening geopolitical tensions after Pakistan retaliated against India’s “surgical strike” by its own version of the air strike, while India also responded; both claim to shot down each other’s fighter jets. The overall situation is now turning very serious like an all-out war and there is some global risk-aversion move as ultimately at the end of the day, an Indian pilot was captured alive by Pakistan from a crashed Mig-21 fighter jet in its territory. The USD was also under stress on the concern of damaging testimony by Trump’s former lawyer Cohen.
The risk-on trade was under pressure on a dramatic escalation in India-Pakistan hostilities after Pakistan reportedly shot down two Indian fighter jets and also bombed near some military installations in the Kashmir LOC area to “demonstrate its military capability in broad daylight”. The Pakistani action came a day after India’s Air Force jets bombed (claimed to be laser guided 1000 kg), what it said was a terrorist training camp (JEM) inside Pakistan (Balakote).
Furthermore, at least three Pakistan fighter jets have entered the Indian side of Kashmir and Indian Air Forces intercepted the Pakistani planes. It was later reported that an Indian Air Force jet has crashed in Pakistan occupied Kashmir. Pakistan Foreign Ministry confirms they have shot down two Indian planes and arrested a pilot, states that we have no intention of escalation, but are prepared to do so if forced into that situation.
The US Secretary of State Pompeo spoke to the Indian and Pakistani Foreign Minister separately and urged Pakistan to avoid military action against India following the previously reported Indian air strike on a terrorist camp on Pakistan. China also urged restraint on both the nuclear neighbors amid escalating tensions and mini-war like situation across the LOC.
In any way, the market is concerned that lingering India-Pakistan conflict coupled with a host of other geopolitical uncertainties from China trade talks to Brexit could hamper the global economic growth. The US President Trump is also in Vietnam for a second summit with North Korean leader Kim, with the outcome uncertain and any big failure in North Korean Nuke war truce could also affect the US-China trade war truce.
Meanwhile, Powell’s testimony on Tuesday gave no indication that the Fed is ready to alter its hawkish monetary policy any time soon. The Fed Chair Powell said during two hours grilling by the US Senators (Senate Banking Committee) that the central bank would be data dependent and has “no rush to make a judgment” about further changes to interest rates amid mixed US economic data. Powel also clarified that “crosscurrents and conflicting signals” pushed the Fed to take a more patient approach to raise interest rates in January.
In the semi-annual testimony, Powell said there were “crosscurrents and conflicting signals” in the past few months. He explained that the conflicting signals include disappointing data, like retail sales in Dec, that’s in contrast to strong job data. But Powell emphasized “for now we have the makings of a good outlook and our committee is really monitoring the crosscurrents, the risks, and for now we are going to be patient with our policy and allow things to take time to clarify and going forward, our policy decisions will continue to be data dependent and will take into account new information as economic conditions and the outlook evolve.”
On monetary policy, Powell reiterated that “the extent and timing of any further rate increases would depend on incoming data and the evolving outlook.” He noted that the headline inflation pressure was “muted in January amid oil volatility and the cumulative development warranted taking a patient approach to future policy changes”. Also, the Fed will evaluate the appropriate timing and approach for the end of balance sheet runoff in the days ahead.
Powell said: “The baseline outlook is a good one, but slower growth overseas is a drag on the US economy that we may feel more of in the coming months. We have the makings of a good outlook and our (rate-setting) committee is really monitoring the crosscurrents, the risks, and for now, we are going to be patient with our policy and allow things to take time to clarify. The flow of new workers into the labor force, for example, has surprised the central bank and means there is more room to grow”. Powell affirmed the Fed’s official view that the US economy may grow solidly but at a slower pace this year than the estimated 3% GDP growth for 2018.
Powell raised the concern of weak productivity and public debt, which he said is "on an unsustainable path”. Among positive economic signs, Powell cited stronger US wage growth, especially among lower earners, as well as increased labor force participation.
On Fed’s B/S tapering (QT), Powell affirmed that the central bank is prepared to adjust B/S tapering if needed: "I would note that we are prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. In the longer run, the size of the balance sheet will be determined by the demand for Federal Reserve liabilities such as currency and bank reserves”.
As a pointer, the Fed's total B/S size was around $4.5T before the QT starts and is now around $4T due to the tapering (reduction/roll off) in auto-pilot mode at $50B/pm; the rest being still reinvested. Thus this is a partial QT.
On Tuesday, for the first time, Powell put an estimate on where bank reserves would end up before the Fed ends the QT. He said the likely level is around $1 trillion "plus a buffer," a number he said, "is a reasonable starting point." Bank Reserves are currently just over $1.6 trillion.
The market assumed that at this rate of $50B/pm, the Fed may close its QT as early as by Dec’2019 and the USD slumped, giving some boost to the equities. But that may not be the case at all as the Fed may keep the overall B/S size around $2.5T and thus at the auto-pilot rate, the QT may end by late 2020 or 2021 and the US stocks slip in the closing hours. In any way, the Fed will now increasingly debate about the appropriate size of its B/S for a Goldilocks US economy and will divulge a QT tapering plan in the coming Fed meetings.
On the global economy, Powell sounded cautious and dovish as usual and said: “financial conditions are now less supportive of growth than they were earlier last year, but growth has slowed in some major foreign economies, particularly China and Europe.”
On growing US fiscal deficits, Powell looked cautious and said: “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong. I think that the US debt is fairly high as a level of (GDP) and, much more importantly than that, it’s growing faster than GDP. To the extent that people are talking about the Fed - our role is not to provide support for particular policies on environmental, social or other related issues”. When asked about the upcoming need to boost the US debt ceiling, he said: “I considered the prospect of a US government default on its obligations is a bright line and I hope we never do pass it”.
Overall, Powell’s Tuesday remarks have nothing new and may be termed as less dovish than expected or simply neutral, showed no urgency toward further rate hikes or cuts in 2019, whereas the market was expecting some definitive signal for Fed pauses and QT tapering. Powell has not taken any rate hike options off the table and his overall statement and comments do not mean that the Fed will be on hold or pause mode for entire 2019.
Full statement by Powell in the Semiannual Monetary Policy Report to the Congress:
“Good morning. Chairman Crapo, Ranking Member Brown, and other members of the Committee, I am happy to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress”.
“Let me start by saying that my colleagues and I strongly support the goals Congress has set for monetary policy–maximum employment and price stability. We are committed to providing transparency about the Federal Reserve’s policies and programs. Congress has entrusted us with an important degree of independence so that we can pursue our mandate without concern for short-term political considerations. We appreciate that our independence brings with it the need to provide transparency so that Americans and their representatives in Congress understand our policy actions and can hold us accountable. We are always grateful for opportunities, such as today’s hearing, to demonstrate the Fed’s deep commitment to transparency and accountability”.
“Today I will review the current economic situation and outlook before turning to monetary policy. I will also describe several recent improvements to our communications practices to enhance our transparency”.
Current Economic Situation and Outlook:
“The economy grew at a strong pace, on balance, last year, and employment and inflation remain close to the Federal Reserve’s statutory goals of maximum employment and stable prices‑‑our dual mandate”.
“Based on the available data, we estimate that gross domestic product (GDP) rose a little less than 3 percent last year following a 2.5 percent increase in 2017. Last year’s growth was led by strong gains in consumer spending and increases in business investment. Growth was supported by increases in employment and wages, optimism among households and businesses, and fiscal policy actions”>
“In the last couple of months, some data have softened but still point to spending gains this quarter. While the partial government shutdown created significant hardship for government workers and many others, the negative effects on the economy are expected to be fairly modest and to largely unwind over the next several months”.
“The job market remains strong. Monthly job gains averaged 223,000 in 2018, and payrolls increased an additional 304,000 in January. The unemployment rate stood at 4 percent in January, a very low level by historical standards, and job openings remain abundant. Moreover, the ample availability of job opportunities appears to have encouraged some people to join the workforce and some who otherwise might have left to remain in it”.
“As a result, the labor force participation rate for people in their prime working years‑‑the share of people ages 25 to 54 who are either working or looking for work‑‑has continued to increase over the past year. In another welcome development, we are seeing signs of stronger wage growth”.
“The job market gains in recent years have benefited a wide range of families and individuals. Indeed, recent wage gains have been strongest for lower-skilled workers. That said, disparities persist across various groups of workers and different parts of the country. For example, unemployment rates for African Americans and Hispanics are still well above the jobless rates for whites and Asians”.
“Likewise, the percentage of the population with a job is noticeably lower in rural communities than in urban areas, and that gap has widened over the past decade. The February Monetary Policy Report provides additional information on employment disparities between rural and urban areas”.
“Overall consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), is estimated to have been 1.7 percent in December, held down by recent declines in energy prices. The Core PCE inflation, which excludes food and energy prices and tends to be a better indicator of future inflation, is estimated at 1.9 percent”.
“At our January meeting, my colleagues and I generally expected economic activity to expand at a solid pace, albeit somewhat slower than in 2018, and the job market to remain strong. Recent declines in energy prices will likely push headline inflation further below the Federal Open Market Committee’s (FOMC) longer-run goal of 2 percent for a time, but aside from those transitory effects, we expect that inflation will run close to 2 percent”.
“While we view current economic conditions as healthy and the economic outlook as favorable, over the past few months we have seen some crosscurrents and conflicting signals. Financial markets became more volatile toward year-end, and financial conditions are now less supportive of growth than they were earlier last year. Growth has slowed in some major foreign economies, particularly China and Europe. And uncertainty is elevated around several unresolved government policy issues, including Brexit and ongoing trade negotiations. We will carefully monitor these issues as they evolve”.
“In addition, our nation faces important longer-run challenges. For example, productivity growth, which is what drives rising real wages and living standards over the longer term, has been too low. Likewise, in contrast to 25 years ago, labor force participation among prime-age men and women is now lower in the United States than in most other advanced economies”.
“Other longer-run trends, such as relatively stagnant incomes for many families and a lack of upward economic mobility among people with lower incomes, also remain important challenges. And it is widely agreed that federal government debt is on an unsustainable path. As a nation, addressing these pressing issues could contribute greatly to the longer-run health and vitality of the U.S. economy”.
Monetary Policy:
“Over the second half of 2018, as the labor market kept strengthening and economic activity continued to expand strongly, the FOMC gradually moved interest rates toward levels that are more normal for a healthy economy. Specifically, at our September and December meetings, we decided to raise the target range for the federal funds rate by 1/4 percentage point at each, putting the current range at 2-1/4 to 2-1/2 percent”.
“At our December meeting, we stressed that the extent and timing of any further rate increases would depend on incoming data and the evolving outlook. We also noted that we would be paying close attention to global economic and financial developments and assessing their implications for the outlook”.
“In January, with inflation pressures muted, the FOMC determined that the cumulative effects of these developments, along with ongoing government policy uncertainty, warranted taking a patient approach with regard to future policy changes. Going forward, our policy decisions will continue to be data dependent and will take into account new information as economic conditions and the outlook evolve”.
“For guideposts on appropriate policy, the FOMC routinely looks at monetary policy rules that recommend a level for the federal funds rate based on measures of inflation and the cyclical position of the U.S. economy. The February Monetary Policy Report gives an update on monetary policy rules. I continue to find these rules to be helpful benchmarks, but, of course, no simple rule can adequately capture the full range of factors the Committee must assess in conducting policy. We do, however, conduct monetary policy in a systematic manner to promote our long-run goals of maximum employment and stable prices. As part of this approach, we strive to communicate clearly about our monetary policy decisions”.
“We have also continued to gradually shrink the size of our balance sheet by reducing our holdings of Treasury and agency securities. The Federal Reserve’s total assets declined about $310 billion since the middle of last year and currently stand at close to $4.0 trillion. Relative to their peak level in 2014, banks’ reserve balances with the Federal Reserve have declined by around $1.2 trillion, a drop of more than 40 percent”.
“In light of the substantial progress we have made in reducing reserves, and after extensive deliberations, the Committee decided at our January meeting to continue over the longer run to implement policy with our current operating procedure. That is, we will continue to use our administered rates to control the policy rate, with an ample supply of reserves so that active management of reserves is not required”.
“Having made this decision, the Committee can now evaluate the appropriate timing and approach for the end of balance sheet runoff. I would note that we are prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. In the longer run, the size of the balance sheet will be determined by the demand for Federal Reserve liabilities such as currency and bank reserves. The February Monetary Policy Report describes these liabilities and reviews the factors that influence their size over the longer run”.
“I will conclude by mentioning some further progress we have made in improving transparency. Late last year we launched two new publications: The first, Financial Stability Report, shares our assessment of the resilience of the U.S. financial system, and the second, Supervision and Regulation Report, provides information about our activities as a bank supervisor and regulator. Last month we began conducting press conferences after every FOMC meeting instead of every other one”.
“The change will allow me to more fully and more frequently explain the Committee’s thinking. Last November we announced a plan to conduct a comprehensive review of the strategies, tools, and communications practices we use to pursue our congressionally assigned goals for monetary policy. This review will include outreach to a broad range of stakeholders across the country. The February Monetary Policy Report provides further discussion of these initiatives”.
“Thank you. I am happy to respond to questions”.
Overall, from the above-written statement, it’s almost clear that the Fed/Powell is confident about the US price stability (close to 2% core PCE inflation) and as oil is also bouncing back, the headline inflation should improve in the coming months.
As the Fed is almost near its hiking cycle with maximum 2-more hikes for a mean neutral rate of +3.00%, the focus is now on the QT. The Fed is now debating actively about an appropriate size of its B/S, relevant to the current US economic conditions. Powell previously indicated that the B/S size will be much higher than the pre-GFC period (around $1T), but will be substantially lower than the post-GFC peak of $4.5T.
Thus, the Fed could settle around $2.5T for its B/S size and at the present auto-pilot rate of $50B/pm; i.e. $600B/pa, it will take at least another 2.5 years (H2-2021) for the Fed to normalize its B/S size and close the QT.
As the Fed believes that QT is not responsible for the December stock market plunge amid low year-end liquidity, it could continue the QT, keeping the rate action as the primary policy tool. And to prevent any unwarranted surge in bond yields or inversion as a result of QT, the Fed may also use another policy tool like YCC (yield curve control) in line with BOJ (as per recent comment by the Fed VC Clarida).
In the meantime, the Fed also ready or flexible enough to end the QT (at least temporarily) for any unwanted economic scenario, like severe slowdown or even a recession as a result of increasing geopolitical tensions (such as Brexit), Trump’s bellicose trade policies and resultant China & EU slowdown.
But on the 2nd day (Wednesday) of his testimony, Powell said: “The Fed will be announcing something (QT tapering plan) very soon on the balance sheet as we are close to an agreement on the plan for managing the balance sheet. The unrealized losses on the Fed’s B/S don't affect policy. The size of the B/S is to be driven by demand for liabilities and we are nearing agreement on a plan for the B/S”.
Then Powell clarified further: “I expect the balance sheet plan to involve ending balance sheet run-off this year. We are going to be in a position to stop run-off of balance sheet this year. We have a bunch of decisions to make on balance sheet; the one about MBS sales is at the back of the line. I see the post-crisis balance sheet at about 16%-17% of GDP”.
Thus, as per Powell, the Fed could be in a position to stop the QT by 2019. Dow jumped and USD slips on Powell’s clear comments about ending the QT. But Powell also indicated post-GFC B/S size at around 15% of the US GDP.
At around $20.35T of projected GDP by 2019 (actual GDP $19.39T at 2017), the Fed’s B/S size could be around $3T, whereas the present size is around $4T. In other words, at the present auto-pilot rate of $600B/pa, the Fed will need at least 16.6 months; i.e. by H2-2020, the Fed could probably stop the B/S tapering (at $3T B/S size and mean neutral rate of 3.00%).
The market has already discounted this B/S tapering closing by H2-2020, a year earlier than the original schedule. Subsequently, Dow slips from the session high and USDJPY was able to break the 111.00 barriers and made a session high of 111.08 on late Wednesday. But the Fed could also stop the QT earlier partially by adjusting the MBS sales.
On the overall prospect of the US economy, Powell said in his 2nd day of testimony: “The Fed is going to be patient and watch as the economy evolves, but the unsustainable path of Federal government’s spending is a long run problem. The US wages have been moving up nicely in the past year and the fiscal package supported demand in 2018. The 2018 GDP growth looks near 3%, maybe a little under. The overall picture of household debt is basically healthy, but student debt as one area of concern”.
Another point in the 2-day testimony is Trump’s influence (pressure) on the Fed to abandon the hawkish path. On Tuesday, when Powell asked by the US Lawmakers whether there had been any “direct or indirect” communication from the White House (Trump) about interest rates, he dodged the actual question, saying he would not comment on private conversations with other officials and reiterated his pledge that the Fed will make policy decisions “in a way that is not political”.
As lying to a US Congressional testimony is a criminal offense, Powell dodged the question and responded indirectly rather than simple ‘yes’ or ‘no’. A few months ago, Trump invited Powell in a Friday dinner along with the US Treasury Secretary Mnuchin to discuss the overall US economy and monetary policy. At that time Powell denied to provide any unpublished Fed view to Trump and also made it clear that the Fed will do its work as per incoming economic data and some other considerations and its future outlook (implications) without any “political pressure”.
But Powell is now trying to keep a fine balance between Fed independence and Trump’s political pressure (no US President would like a hawkish Fed) and thus preparing the market for an eventual end of Fed’s dual QT (rate hikes and B/S tapering). The Fed may close the rate hiking cycle by Dec’2019 after two more hikes for a mean neutral rate of 3.00% and may also close the B/S tapering at around $3B size by H2-2020. This is somewhat more hawkish than the market has already discounted in the last few months amid various Fed speeches and thus the USD is now getting some boost.
As per reports, the Fed has so far dumped another $58B in assets from its B/S in February, the largest so far. This shows that for now, the Fed has no intention of reversing QT, despite all the dovish talk in the Wall Street that the Fed will soon stop its “loco” and instead may launch “helicopter money” (QE-4) by 2019 end.
Trump, on his part, may also keep the China trade tensions alive despite “huge progress” and a likely trade deal with China during a March summit with Xi. The hawkish stance of the USTR Lighthizer in his China trade testimony Wednesday was another such indication and although Trump will not hike China tariffs to 25%, he may not withdraw his earlier tariffs of 10% either for “lack of structural reforms” from China. This is designed to keep the Fed to continue abandoning the hawkish path amid China/global slowdown and lower inflation in the US (as 25% tariffs on $200B Chinese consumer goods could stroke higher core inflation in the US economy).
Technically, whatever may be the narrative, USDJPY now has to sustain over 111.15 for a further rally to 111.50*/112.50-112.80*/113.15 and 113.75/114.15-114.75/115.50 in the near term (under bullish case scenario).
On the flip side, sustaining below 110.95, USDJPY may fall to 110.30*/110.10-109.50/108.50* and 107.90/107.50-106.80/106.20 in the near term (under bear case scenario).
On early Thursday, USDJPY is currently trading around 110.75 in the pre-EU session, slumped by almost -0.20% on reports that the working lunch session of Trump-Kim summit (2nd day) has been canceled abruptly without any official joint public statement or joint signing ceremony. Trump motorcade has departed the Metropole hotel in Hanoi (Vietnam) and the Hanoi summit ends early as Kim also departed the hotel. Probably it’s a big failure for Trump and also negative for the US-China trade truce.
When the US reporters asked Kim Jong if he is to take detailed denuclearization steps or not ready yet. Kim said: “We are talking about that just now… (They all) seem very curious”. Trump may make a statement shortly, while the White House commented that although no official agreement has been reached at the summit, talks are "good" and "constructive".
Pivot: 111.15 Support: 110.3 110.1 109.5 Resistance: 111.5 111.8 112.5 Scenario 1: Strong above 111.15 and sustaining above 111.50/111.80*-112.50/112.80*, USDJPY may further surge to 113.15/113.75*-114.15/114.75* and 115.50 in the near term Scenario 2: Weak below 110.95 and sustaining below 110.30*/110.10-109.50/108.50* , USDJPY may further plunge to 107.90/107.50-106.80/106.20 in the near term Comment: Short term range: 109.50/110.10-111.80/113.75