US Dollar: Next Leg of Collapse Rests in FOMC’s Hands

October 26, 2013

New York (Oct 26)  Conditions are ideal. That would be the simple interpretation of our circumstances if we were to take the S&P 500’s record highs and the collapse in volatility at face value. And, in financial market ‘perfection’, the US dollar is a flawed safe haven that participants are intent to avoid. Yet, we know that the global economy and market are far from perfect. Instead of promising growth and returns, the market has taken a dangerous foothold in moral hazard and leverage. This presents a precarious situation of dormant disaster; yet mere concern is falling short of keeping the dollar from its tumble. To avoid a deeper plunge, the currency requires fear and deleveraging.

Whether the market extends its yield grab through a period of suspicious calm or rushes for the exit amid panic could once again prove a function of a single focus – if not catalyst – the FOMC rate decision. Last week, the spotlight was on the delayed September nonfarm payrolls (NFP) data. This indicator was seen as an ideal confirmation to what bulls had come to expect: that the September Fed meeting, growth impact of the US government shutdown and delayed data would translate into a longer delay for the dreaded Taper. The market seemed to find what it was looking for as equities jumped and the USDollar stumbled after the data was released.

Yet, the reaction notwithstanding, the data did more to pressure the central bank to stick to its policy guidance. The downtick in the jobless rate to 7.2 percent brings the benchmark to within 0.2 percentage points of the objective Chairman Bernanke laid out back in June that would correlate to the end of the QE3 program. Notably, the group has not officially backtracked on those forecasts – reminders of data dependency only reinforce it. Many find fault with the data itself; but faulty or not, if it is used to set policy, that is what matters.

Admittedly with the jobs statistics, it was easy to impress a bias. The miss in the headlines payrolls number was all that was needed for a market looking for a reason. The upcoming Fed decision may not be as easy to game. This is not one of the quarterly meetings that offers updated forecasts and official press conference – the next such meeting is December. However, the statement that accompanies the decision will be run through with a fine-toothed comb. Should we be riding record highs in equities, nervous investors that were only recent converts to the rally may demand reassurances with meaningfully-softer language. Maintaining the status quo could therefore carry a negative connotation. If markets are softer into the event, it would only leverage that threat.

The complications come should the Fed try to fulfill hopes and alter their language to further reassure investors. What level of reassurance is enough simple to keep the market steady, and what would be needed to drive appetites even further? That remains to be seen. Ambiguity in vague central bank reassurances will not be the only thing the market latches on to though. Ensure Wednesday will be particularly remarkable for headlines and stored volatility, we will also have the (delayed) September CPI figures and October ADP employment change. These are objective data readings that contribute directly to the Fed’s dual mandate of ‘maximum employment’ and ‘stable prices’.

Forecasts heading into the week project the ADP jobs figure to cool (150,000 – no jobless rate assumptions which is what the Fed actually looks at) and headline inflation to drop back to 1.2 percent (against a previous 1.5 percent reading and long-run target of 2.0 percent). We have to presume that this is already priced in. As such surprise once again favors the dollar positive outcome.

It is important to remember why the monetary policy meeting carries so much weight: it taps into risk trends. Risk trends that are fed increasingly by accommodative policy as a substitute for underlying growth and attractive returns. It is a perilous balance to attempt to maintain where investors are encouraged to take of excessive risk in order to make returns that are commensurate with a benchmark like the S&P 500 that is a symbol of that ‘moral hazard’. It does not pay to trade as a skeptic in a realist’s market, but it is prudent to bear in mind their concerns should they become reality.

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