Federal Reserve’s 5 Step Exit Strategy

According to the minutes from the April Federal Reserve monetary policy meeting, here is the 5 step exit strategy that policymakers prefer at this time:

1) End QE2 in June
2) Stop reinvestment some time this yr
3) Remove the “extended period” language in Q4 or early 2012
4) Raise interest rates
5) Start selling assets in 2012/2013

Nearly all of the FOMC members agreed that the first step should be to stop reinvesting payments of principal on agency securities and then soon after Treasury securities. By doing this, they would be reducing the size of the central bank’s balance sheet which would be a small step towards policy tightening. Changes to the FOMC statement regarding forward policy should also happen at that time. The second step would be to raise interest rates and then gradually sell off their existing securities. The reason why they are leaning towards raising rates first is because it would give them the flexibility to lower rates later if economic conditions then warranted. Although talk of an exit strategy has helped to lift the U.S. dollar, the Fed also said that discussions of an appropriate exit strategy does not mean that they are looking implement one soon.

Dollar will Stabilize when Yields Stop Falling

Saying the U.S. dollar is falling out of bed would almost be an understatement given the recent price action in the greenback. Over the past three months, the dollar lost more than 10 percent of its value against the euro, Swiss Franc and Australian dollar. Since July, every one of the G10 currencies outperformed the debilitated buck and the latest dollar dump has even driven some currencies to significant highs. The greenback is the one currency that no one wants to own right now but the currencies that are in greatest demand are the Japanese Yen, Swiss Franc, and Australian dollar. The reason why investors are buying the Swissie and Aussie in size is because of their stable economies, healthy economic outlook and correlation with gold prices. The Yen on the other hand is being bought not because their economy is performing better than the U.S., but because investors are seeking safety in low yielding currencies that are not the dollar, the Chinese are buying Japanese bonds, exporters are hedging and carry trades are continuing to unwind their long dollar, short yen positions.

Today’s sell-off in the dollar today pushed the euro above 1.40, the Yen to a fresh 15 year high against the greenback, the Swissie and Aussie to a record high. Although the weakness of the dollar can be attributed to concerns about the U.S. labor market, the primary reason why the dollar came under assault is because U.S. yields continue to fall. Of course these factors are related since weaker economic data raises the chance of the Fed following through with additional asset purchases which are bearish for yields, but what is important is that bond traders have been particularly in tune with the market’s sentiment. Two year Treasury yields fell to a fresh record low of 0.359 percent while ten year yields dropped to the lowest level since January 2009. The dollar will continue to fall as long as U.S. yields continue to decline. If there is any hope for a rebound in the greenback, we would need to see U.S. yields stabilize first. The following chart shows the strong relationship between USD/JPY and U.S. yields. Since the beginning of the year, the correlation between these instruments on a week to week basis has been approximately 90 percent!

How Far Can USD/JPY Fall?

The U.S. dollar fell to a 7 month low against the Japanese Yen this morning following another barrage of weak economic data. Consumer prices fell, foreign inflows decreased and the UMich consumer confidence survey dropped to the lowest level since August 2009. On FX360.com, I talked incessantly in my daily report about how the data today was going to be weak and yesterday, I said USD/JPY was going to fall to at least 87. However now that it has broken below that point, the burning question on everyone’s minds is How Much Further Can it Fall?

My updated target is at least 85.00 – The currency pair’s 14 year low. When USD/JPY reaches that point, expect Bank of Japan officials to cry uncle and attempt to talk down the Yen (and up the dollar). That will most likely create some 2 way risk in USD/JPY and stem the currency’s slide. Yesterday, Shirakawa already warned that they are watching USD/JPY closely.

Enjoy the chart, enjoy the trade.

Impact of New Japanese Prime Minister on Yen

Japan announced a new Prime Minister this morning – Naoto Kan. Hopefully he will have better luck than his 4 predecessors who resigned with only a year or less in service.

Resignations by Prime Ministers can have a significant impact on the country’s currency because its performance reflects investor sentiment. Forex traders typically do not like change and when Hatoyama announced his resignation, USD/JPY rose from 90.95 to 92.35 as the Yen as plummeted against the U.S. dollar. To get a sense of how the Yen could trade going forward, it is worthwhile to look back at how the currency behaved before and after the resignations of previous Prime Ministers.

The following charts suggest that the recent gains in USD/JPY may be temporary because once the political uncertainty from the Prime Minister’s resignation subsides, USD/JPY usually resumes it slide. Hopefully the new Prime Minster, Naoto Kan can break the unlucky chain and hold onto the post for more than a year.

Taro Aso (click to expand)

Yasuo Fukuda (click to expand)

Shinzo Abe (click to expand)

Video: What to Expect from ECB, BoE and Non-Farm Payrolls

I was on Fox Business this afternoon talking about the overstretched positions in the euro and British pound as well as the outlook for the ECB, BoE and Non-farm payrolls report

If the video doesn’t load, watch it here Kathy’s Fox Business Interview