How Dollar Responds to FOMC Hinges on 2 Variables

March 19, 2014

New York (Mar 19)  The U.S. dollar and Treasury yields traded lower ahead of Janet Yellen’s very first monetary policy meeting as Federal Reserve Chairwoman. She has big decisions to make that could set the tone for her time at the Fed but luckily investors have a good grasp of her potential announcements. It is widely believed that the central bank will reduce asset purchases by another $10 billion and drop its unemployment rate threshold in favor of qualitative guidance. The market has already priced in these changes, which leaves the U.S. dollar’s reaction to FOMC contingent upon 2 variables.

The first is what Qualitative Guidance looks like. When the Bank of England abandoned their unemployment threshold, they tied future policy tightening to the slack in the labor market. The current FOMC statement already contains some details on qualitative guidance. In the last statement, the central bank said other measures such as “labor market conditions, indicators of inflation pressure and inflation expectations and readings on financial developments,” will determine how long a highly accommodative monetary policy stance is maintained. If Yellen uses these indicators as measures of qualitative guidance, they will be specific enough for the market to understand that employment and inflation are the central bank’s primary focus and vague enough to provide no additional information on the timing of future rate hikes. If the central bank does not elaborate on these measures and simply ties forward guidance to what is currently in the FOMC statement, investors will be disappointed and the dollar’s reaction will be limited. For central banks comfortable with their current course of monetary policy, saying less could be doing more for the economy so this could be an ideal choice for Yellen. However if she chooses to be more transparent and provides more specifics or additional conditions, the dollar could have a more significant reaction.

The second will be the Federal Reserve’s latest economic projections. As these are hard numbers there is very little ambiguity. If the central bank lowers its 2014 GDP forecasts because of weak growth at the start of the year, investors could sell dollars if they interpret this to mean a more pessimistic outlook for the economy. If they leave their GDP forecast unchanged, it could be interpreted as a slightly more optimistic outlook for the rest of the year, which would be positive for the greenback. Their forecasts for the unemployment rate will also be lowered but we are not looking for any significant changes to the central bank’s inflation projections.

EUR Resilient in the Face on Ongoing Ukraine/Russia Crisis

The euro has been extremely resilient in the face of the ongoing crisis between Russia and the Ukraine. This morning, Russian President Vladimir Putin officially signed a treaty to accept Crimea into the Russian Federation and in a direct challenge to the West, the Russian government has moved fast to bring Crimea into its fold. Within 3 months, they expect the Ruble to replace the Ukrainian hryvnia as the local currency. Putin also announced plans to respond to US and EU sanctions with their own restrictions. Their complete rejection of the West’s calls to de-escalate tensions should have led to a flight to quality into U.S. dollars and out of euros but the EUR/USD held steady as investors latched onto the hope that Russia’s incursion into Ukraine will stop at Crimea. According to Putin, there is no need to break up Ukraine even further and if he stays true to his words, the tensions between Russia and the West could begin to fade and the improvement in risk appetite could be sustained. This mere possibility has already driven equities higher and kept the EUR/USD afloat. Unfortunately we feel this positive sentiment is still wishful thinking because sanctions from Russia could lead to a more aggressive response from the West. Russia has already been suspended from the G8 and could be isolated even further. They boosted their troops at the Ukraine border, raising concerns that they are poised for a quick invasion that explains why euro has given up its initial post Putin gains. So while Russia’s statement today could be positive for euro, actions speak louder than words and so far, there are plenty of reasons to believe that the crisis in Ukraine will worsen before it improves.

Source:  bkassetManagement

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