What'll The FOMC Release Do To The USD?

Since the beginning of the week, the U.S. dollar has been trading in a narrow range as investors wait for new direction from the Federal Reserve. The central bank began the long process of unwinding stimulus last year and while Bernanke laid out a plan for tapering, his influence will be limited to one more meeting. This makes it extremely important to understand the motivation and level of enthusiasm for last month's reduction because it will help us determine whether the central bank will stick to his proposal for cutting bond purchases by $10 billion at each subsequent meeting. While the dollar traded higher on the back of stronger trade numbers, the drop in 10 year bond yields suggests that investors believe that under Yellen the central bank could be less aggressive. That's a separate discussion that we will touch on later but more immediately, the focus is on the FOMC minutes and how it could affect the dollar.

Here's what we know about the last monetary policy decision:

Janet Yellen voter to taperTaper nothing more than symbolic - $10B split between Treasuries and MBS

1. Janet Yellen voter to taper
2. Taper nothing more than symbolic - $10B split between Treasuries and MBS
3. Fed changes forward guidance - Low rates now appropriate "well past the time that the unemployment rate drops below 6.5%"
4. Bernanke believes FOMC will taper QE probably at each meeting, $10B each time with end of QE before 2014 year end
5. Fed says tapering will be "in further measured steps at future meetings," determined "deliberately", data dependent
6. Bernanke stresses highly accommodative stance, emphasizes that purchases will go on at rapid rate even after taper
7. Decision was NOT unanimous - Rosengren voted to keep asset purchases unchanged
8. Majority of Fed officials see first rate hike in 2015
9. Low inflation is a problem - "more than a bit of a concern." Fed now sees PCE at 1.4%-1.6% in 2014
10. Fed tightens up GDP forecasts, sees faster drop in jobless rate, 6.3%-6.6% by end of 2014

If the FOMC minutes show a lot of enthusiasm for tapering with a chorus of central bankers supporting consistent reductions going forward, the dollar should rally taking USD/JPY up to 105 and the EUR/USD below 1.36. However if there are widespread concerns about the high level of unemployment and low inflation with policymakers emphasizing that a predetermined course is inappropriate and future decisions should be data dependent, the dollar will resume its slide driving USD/JPY below 104 and the EUR/USD towards 1.37. Aside from the FOMC minutes, ADP will also release its private payrolls report but this should take a back seat to the notes from the last central bank meeting.

Janet Yellen was confirmed as Fed Chair on Monday making her the first female to lead the world's most influential central bank. Having served as the Vice Chair of the Federal Reserve since 2010, she is not new to the FOMC but her voice will be heard much louder this year in the highly anticipated quarterly post monetary policy meeting press conferences. Yellen is a vocal dove that puts growth ahead of inflation but actions speak louder than words and her vote to taper asset purchases in December suggests that as Fed Chair, she may not be as dovish. Every year, the makeup of the Federal Open Market Committee changes with previous voters rotating out and new voters rotating in. This year's policymakers have the huge responsibility of determining the pace that asset purchases will be tapered and when Quantitative Easing will end.

Two major doves favoring easier versus tighter monetary policy (Evans and Rosengren), one moderate hawk who favors tighter policy (George) and one centrist (Bullard) will be rotating out of voting positions. They will be replaced by Plosser and Fisher, two major hawks, Pianalto a moderate dove and Kocherlakota, who shares a similar bias as Yellen. Former Bank of Israel Governor Stanley Fischer has been nominated to replace Yellen as Vice Chair and if confirmed, another hawk would be added to the roster. This would leave the central bank more hawkish and willing to follow Bernanke's proposal for reducing asset purchases by $10 billion at each subsequent meeting. So while the Federal Reserve will be replacing one dove with another as Fed Chair, on balance the FOMC contains more hawks in 2014, which is bullish for U.S. rates and positive for the dollar. Therefore Yellen's confirmation doesn't make the FOMC as a whole more dovish in 2014.

EUR: ECB to Weigh Inflation vs. Growth
Stronger than expected German consumer spending and labor market numbers failed to lend support to the euro because core consumer prices in the Eurozone dropped to a record low. The European Central Bank meets this week and it will be interesting to see how they view these recent developments. On the one hand, low inflation has become a bigger problem and on the other, conditions in Germany have improved. The hope is that stronger German growth will drive up prices but with weak growth in other parts of the region, a rise in CPI is far from assured. Low inflation was the motivation for the ECB's rate cut in November and with consumer prices growing by a mere 0.8%, CPI is far below their 2% target. However policymakers have made it clear that deflation is not a risk, which suggestions that they are not worried about deflation. On Thursday the central bank will most likely remind investors that they can drop interest rates to negative levels if needed but with the German economy gaining momentum, their parting line will be that current monetary policy is appropriate. In December, German unemployment dropped by the largest amount in 2 years. The recent improvements in the labor market helped to boost consumption with November retail sales growing at its fastest rate in a year. We look forward to a stronger German trade balance and factory orders report Wednesday and expect an uptick in Eurozone retail sales.

GBP: 3 Drivers for 2014 Growth
Due to the lack of economic data, there has been very little movement in the British pound Tuesday. Yesterday's PMI services report confirmed that December was a slower month but that does not change our outlook for stronger U.K. growth this year. In 2014, growth in the U.K. will be driven by housing, banking and a stronger global economy. The U.K. government did a fantastic job of propping up the housing market in 2013 with the Funding for Lending Scheme and the Help to Buy program. Their pledge to keep interest rates low will keep mortgage rates cheap, driving property prices higher and attracting foreign investment in 2014. The U.K. government understands that reflating the housing market is the key to keeping the economy supporting and consumers feeling optimistic. After writing off significant amounts of bad debt, the banking sector is also expected to report stronger earnings and dividends in the coming year. A stronger global environment will solidify the recovery and help the U.K. economy reach the Bank of England's 2.8% growth target for 2014, which is significantly higher than the 1.6% growth expected for 2013. However there are areas of concern - slow growth in Europe will limit demand within the region and the high unemployment rate could curtail consumer spending. As such, the BoE will tread carefully in the coming year, leaving stimulus in place for as long as possible. Scotland also has an independence referendum in 2014 but we don't see this as a risk for sterling because the Scots will vote to stay in the union.

CAD: Drops to Fresh 3-Year Lows on Weak Data
Disappointing economic data drove the Canadian dollar to a 3.5 year low against the greenback. The loonie was the day's performing currency as well as its biggest mover. The initial sell-off was triggered by worse than expected trade numbers. Economists had been looking for the small surplus to turn into a tiny deficit but instead the $0.08 billion surplus in October was revised to a -$0.91 billion deficit that increased to -0.94B in November. While exports of auto and parts rose 9.6%, crude oil exports fell 2% leaving overall export growth flat for the month. Imports rose a mere 0.1% due in large part to aircraft orders from the U.S. Canadian trade numbers normally do not have a significant impact on USD/CAD but the combination of a major downside surprise in Canada's report and an upside surprise in the U.S. trade numbers drove USD/CAD above 1.07. However it was the IVEY PMI report that pushed the currency pair to fresh 3 year highs. Manufacturing activity in Canada contracted for the first time in 4 months at its fastest pace in 4 years. The IVEY PMI index dropped to 46.3 from 53.7, highlighting the ongoing challenges facing Canada's economy. Unfortunately the Bank of Canada is in no position to lower interest rates. In fact Finance Minister Flaherty said over the weekend that there would be pressure on the BoC to raise rates with the Fed tapering. Interestingly, this is at odds with his view that a slightly weaker Canadian dollar will help breathe life back into the manufacturing sector. There is no major resistance in USD/CAD until the 2010 high of 1.0855. Meanwhile stronger trade numbers failed to lift the Australian dollar. The country's trade deficit narrowed to -$118 million from -$358 million. A rise in iron ore exports offset the decline in coal shipments. AUD/USD continues to be capped at 90 cents.

JPY: Aso Says 2015 Tax Hike Hinges on 2014 Third Quarter Growth
With the Nikkei edging only slightly lower overnight and 10-year Treasury yields holding steady, USD/JPY managed to find firmer footing above 104. For the time being, the currency pair remains confined between 104 and 105 and the lack of big moves in USD/JPY provided no direction for the Yen crosses. EUR/JPY, GBP/JPY and NZD/JPY traded higher while CAD/JPY, AUD/JPY and CHF/JPY moved lower. The sell-off in CAD/JPY deepened after the disappointing IVEY PMI report. Since the beginning of the year, the currency pair dropped more than 300 pips from a high of 99.15. No major economic reports were released from Japan but Prime Minister Abe said "labor and income conditions are improving." Japan is preparing to raise its consumption tax from 5% to 8% in February and then to 10% next year. According to Finance Minister Aso who touched on the topic Tuesday, the decision to raise taxes in 2015 will depend on how economic conditions are in the third quarter of this year. In other words, if the tax in April leads to a major contraction in growth, the government may delay their plans to raise the tax again. Since it is a quiet week in Japan with no major economic reports scheduled for release, the near term outlook for the Yen will continue to hinge on the Nikkei and risk appetite.

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