Dissecting the Fed Statement

Here is my dissection of the March 16 Fed Statement

FOMC Statement March 16, 2010

Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing ( upgraded “from deterioration in the labor market is abating). Household spending is expanding at a moderate rate but remains constrained by high unemployment ( upgraded from weak labor market), modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly ( upgraded from appears to be picking up). However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level( concern about housing returns) , and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period ( here are the words again). To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month ( Fed ending asset purchases). The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability ( New!).

In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral ( Fed ends liquidity facilities!).

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability ( Hoenig elaborates on dissent).

USD/JPY on a Tear, Key Level

USD/JPY is on a tear this morning. US equities is also trading higher which is completely mind boggling given the fact that US economic data was very weak and Fed Chairman Ben Bernanke warned that we may not be looking at a recovery in the US economy until 2011 or 2012.

There could still be more surprises in Bernanke’s testimony, which is only beginning as he will be facing questioning by the members of the Senate. Although the Q&A session could set the tone for trading this afternoon, the USD/JPY rally has been voracious. Unless there are new revelations from Bernanke, USD/JPY could be headed to 98. The level that it needs to hold above for this to happen is 96.15, the 38.2 percent retracement of the August to January sell-off.

source: eSignal

source: eSignal

Here’s his full testimony:

Chairman Ben S. Bernanke
Semiannual Monetary Policy Report to the Congress
Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, Washington, D.C.
February 24, 2009

Chairman Dodd, Senator Shelby, and members of the Committee, I appreciate the opportunity to discuss monetary policy and the economic situation and to present the Federal Reserve’s Monetary Policy Report to the Congress.

Recent Economic and Financial Developments and the Policy Responses
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Fed Cuts Interest Rates to 0.25% and Formally Enters QE

The Federal Reserve cut interest rates by 75bp to a range of 0 to 0.25 percent, the lowest level that this generation has ever seen.

In our FOMC preview, we talked about how the Fed may consider adopting a BoJ style rate cut that takes interest rates somewhere between 0.25 and 0 percent. Although that was exactly what we saw today, we expected it to happen in March and not December. The Fed has taken another page out of the Bank of Japan’s book and will continue to follow in the footsteps of the Japanese central bank as they formally adopt Quantitative Easing even though they refuse to use those words explicitly.

It is no surprise to see the US dollar selling off aggressively as it is now the lowest yielding G10 currency. This was the right move for a central bank that wants to be proactive and no longer just reactive. There is no point for the Federal Reserve to play games anymore by denying what is already being priced into the markets. Cutting interest rates to 0.25 percent was inevitable and they rather deliver this stimulus now than later. Fed funds were trading as low as 0.15 percent going into the FOMC meeting. The Federal Reserve expects to keep interest rates at “exceptionally low levels for some time,” and to employ all available tools going forward including the purchase of long term Treasuries. In other words, the Federal Reserve is telling us that they are formally moving to Plan B, which is Quantitative Easing.

There is no question now that the Federal Reserve is the most aggressive central bank. Since 2007, they have cut interest rates by 500bp and since the beginning of year, they have cut by 325bp. With the economic outlook weakening and the financial markets remaining quite restrained, the Fed wanted to over rather than under deliver. This morning’s consumer price numbers also raises the risk of deflation, which may have pushed the Federal Reserve to make the larger move. The Fed did not indicate in the FOMC statement whether zero interest rates are still on the table, but an interest rate of 0.25 percent is just as bad.

The US dollar has embarked on a new downtrend and today’s interest rate decision only cements that. We expect more dollar weakness in the first half of 2009. There is a reasonable chance that USD/JPY could fall to 85 and the EUR/USD could break 1.43. And of course, I still love the AUD/USD trade.

Comparing the FOMC Statements:

FOMC Statement December 16, 2008
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Dollar Soars as FOMC Minutes Trigger Liquidation

Despite false rallies in the currency market, I have stressed that there is no reason for the liquidation to be over. I warned that the currency and stock market rallies were a mirage rather than a bottom and now, the pessimistic tone of the FOMC minutes has forced another wave of liquidation.

Tuesday’s rebound in risk appetite was short-lived as the FOMC minutes revealed that the contraction in the US economy could last well into the summer of 2009.

In light of the 400 point drop in the Dow, the US dollar and Japanese Yen regained strength as repatriation and risk aversion continues to drive demand for the low yielders. The greenback’s recent strength can be most clearly seen in USD/CHF, which hit a fresh 14 month high today.

As we predicted, the FOMC minutes was the trigger for a major move in the currency market. However the moves that we have seen today need to be sustained before we can see a more meaningful breakout of the recent consolidation that we have seen across the currency market.

Something more powerful such as a decision on bailing out the automakers, next week’s GDP report or another surprising abysmal loss in the corporate or financial sector may be needed before we see new trends develop.

FOMC Minutes Confirms that More Rate Cuts Needed

The tone in the FOMC minutes, like the tone of Bernanke’s testimony yesterday was unmistakably dovish. The members of the monetary policy committee lowered their growth and inflation forecasts, talked about the downside risks to growth and how the contraction in the US economy will not temper until the middle 2009, at the earliest. Some members of the committee even openly discussed the need for further rate cuts, which confirms that rates will be lowered again in December. The Fed feels frustrated that interest rates are closing in on zero and acknowledged that it leaves them with little room to maneuver. Fed fund futures are pricing in a 50bp rate cut with a minor chance of a 75bp cut to 0.25 percent. If the Fed cuts interest rates by 50bp and the US economy fails to recover, their credibility will go out the window as the market questions their ability to tap other tools to stimulate the economy.

Automakers, Philly Fed and Leading Indicators

The Big 3 Automakers (General Motors, Ford and Chrysler) were on Capitol Hill today pleading for a bailout. Although a bailout of the automobile industry is inevitable in our opinion, it remains to be seen whether lawmakers will act quickly. The longer this drags out, the more pain it will cause for US equities.

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Inflation Eases Big Time in US – More Rate Cuts from Fed

US consumer prices dropped 1 percent last month, taking the annualized pace of growth to 3.7 percent, which is the lowest level since October 2007. Falling oil prices takes the credit for lower inflationary pressures with gasoline prices tracking the 50 percent decline in crude. Gas station receipts fell a whopping 14 percent and commodity prices have fallen in general, which has helped to push down transportation costs.

Although the core PPI numbers accelerated, core CPI dropped 0.1 percent and we expect it to head even lower. Less price pressure will give the Federal Reserve more room to cut interest rates. We expect the Fed to cut by another 50bp in December, but it is important to note that Fed Fund futures are pricing in a tiny chance of a 75bp rate cut next month.

The housing market continues to be one of the weakest links in the US economy. Housing starts fell to a record low while building permits dropped to the lowest level in close to 50 years. When you have an environment where foreclosures are rising at a very rapid pace, there is no desire by builders to break new ground.

This afternoon, we have the minutes from the latest FOMC meeting at which the Fed cut interest rates by 50bp to 1 percent. Given the continued concern reflected in Bernanke’s testimony to the House Financial Services Committee on Tuesday, the Fed is likely to support further easing.

All of the major currency pairs have been consolidating since the middle of last week and the FOMC minutes could be the trigger for a major breakout.
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