April FOMC Preview – 3 Scenarios for the Fed and Impact on Dollar

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In 24 hours the Federal Reserve will announce its monetary policy decision and everyone expects interest rates will remain unchanged.  The Fed has done a great job of preparing the market for steady rates but no changes to monetary policy doesn’t mean  no volatility for the U.S. dollar.

The reason why the April FOMC meeting is important is because it will help to shape expectations for June.  There’s no monetary policy in May so if the Fed wanted to prepare the market for possible tightening, they would need to tweak this month’s FOMC statement. The problem is that the odds of a dollar positive and negative outcome is roughly balanced.  With the global markets stabilizing and commodity prices moving higher, the Fed has less to worry about internationally but domestically, growth has slowed. So even though no changes in monetary policy is expected at this month’s meeting, the greenback could still have a meaningful reaction to FOMC based upon the Fed’s assessment of the economy.

Now lets run through the possible scenarios:

Scenario 1 – The FOMC statement remains virtually unchanged = Mildly negative for the dollar because it would imply an ongoing split within the Fed and reluctance to raise interest rates.

Scenario 2 – Fed acknowledges deterioration in data and leaves out risk assessment = Dollar Bearish
The balance of risks statement was removed from the last 2 monetary policy statements because policymakers could not agree on the outlook for the economy. So if the risk statement is absent again, the dollar could spiral lower as the market interprets it to mean no rate hike in June.

Scenario 3 – Fed acknowledges deterioration in data but describes it as transitory AND the risk statement returns = Dollar Bullish
If the risk statement reappears and the Fed describes the risks are balanced, the dollar will soar as the chance of a June hike increases significantly. Aside from the risk statement the central bank’s comments about recent data disappointments will also be important. If they say the deterioration is transitory, it will help the dollar.

The following table shows how the U.S. economy performed between March and April. An initial glance shows more deterioration than improvements with consumer spending, labor market activity, inflation, production and trade weakening. However there are glimmers of hope. The rally in U.S. stocks helped to boost consumer confidence as measured by the Conference Board’s report, consumer prices are still moving upwards as gas prices increased. New and pending home sales rebounded and most importantly manufacturing and service sector activity accelerated. With average hourly earnings on the rise, the Fed could argue that the economy will regain momentum in the near future and with prices rising, they need to get ahead of inflation expectations. In other words while the data suggests that the Fed should be less hawkish, they could also find reasons to stick to their plan of raising rates twice this year.

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Fed: Data Shows Mkt Pricing in Q2 Rate Hike?

It has been a while since I provided updated numbers for the market’s rate hike expectations and I will chalk it up to my travels! Rate expectations are always changing and a lot has happened over the past month. Its always important to keep track of them because they reflect what investors are pricing in!

Here are the latest numbers and highlights (compared to March)

Fed – One 25bp rate hike expected by Q2 2012 > Compared to Q1 rate hike before
BoE – First Rate hike expected in Jan > compared to prior forecast for 50bp rate hike in 2011
ECB – 50bp of additional tightening expected > compared to 75bp after April hike
RBA – Close to one 25bp rate hike by years end > significant upgrade from March expectations
RBNZ – One rate hike in Jan 2012 > bumped up from March
BoC – 25bp rate hike in Oct > slight downgrade in rate hike expectations

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.