Fed Announcement – Four Possible Scenarios

The biggest event in the forex market this week will be tomorrow’s Federal Reserve monetary policy announcement. On FX360.com, I published an extensive article talking about what the Fed may or may not do (FOMC Preview: The Key Language Changes to Look for)

Here are the possible scenarios for the U.S. dollar:

A) Fed uses the words “balance sheet expansion” in FOMC Statement > Dollar Bearish

B) FOMC Statement contains no hints about additional stimulus > Dollar Bullish

C) Fed announces small scale asset purchases > Very Dollar Bearish

D) Fed alters “extended period” language in FOMC statement > Dollar Bearish

More details can be found in my special report (FOMC Preview: The Key Language Changes to Look for)

How to Trade FOMC

We are witnessing a very powerful move in USD/JPY ahead of the FOMC rate decision. After falling to a low of 95.11 intraday, the currency pair has recovered all of its losses and then some. USD/JPY is now trading back within the Buy Zone, which i determine using Bollinger Bands with a strong hammer formation.

In my FOMC Preview and Daily Report on FX360.com, I talked about how the best game plan for the FOMC decision is to trade USD/JPY. I have been bullish the currency pair going into the rate decision because I think the Fed will have to acquiese by upgrading their outlook for the U.S. economy. If they do, we could see USD/JPY make a run for 97. However if they dowplay the significance of the improvements in the labor market, the reversal could be violent.

Source: eSignal

Source: eSignal

Game Plan for FOMC

Based upon the Fed fund futures which are pricing in a rate hike as early as Q1 and the sentiment in the markets, we know that traders are looking for some sign of optimism from the Federal Reserve. This can come in the form of an upgraded economic assessment, talk of an exit strategy or any other indication that interest rates will not remain low for an extended period of time. In our opinion, the Federal Reserve will probably retain the tone of the previous statement, mentioning only some of the improvements in the economy and avoid talking about an exit strategy. You can find more details about this in our FOMC Preview ( Will the Fed Deliver any Surprises ). However as the U.K. central bank has surprised us with their dovishness while the central banks of Canada and Australia have surprised with their hawkishness, we do not rule out market moving comments from the FOMC. If the Fed changes or drops their “the pace of economic is slowing” and” economic activity is likely to remain weak for a time,” statements, expect a rally in USD/JPY. If they talk of exit strategies and bond yields start to rise, we could see a more dramatic dollar rally. If the Fed disappoints by downplaying the improvements in the U.S. economy, we could see an ugly reversal in the greenback. The currency pair that will have the purest reaction to the FOMC decision will be USD/JPY. Although we also believe that the dollar could rally against the euro on the heels of a positive outcome, it is too early to tell if the dollar is trading on fundamentals or risk appetite. So the best game plan is to focus on USD/JPY.

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Expectations for Central Bank Rate Cuts

Here is an update on central bank rate cut expectations:

Eurozone – 25bp rate cut expected on Thursday

U.K. – No rate cuts for the rest of the year, but watch out for comments on Quantitative Easing

Australia – Rates left unchanged last night. 2.50% expected to be the floor

New Zealand
– One more rate cut in June or July

U.S., Japan and Canada – No rate cuts for the rest of the year

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How Does the Fed “Print Money?”

With the Fed’s announcement today, many people may be wondering “How does the Fed print money?” Here is a snippet from my Daily Piece on Currencies.

Most of the time when we say that a central bank “prints money” that does not mean that they actually fire up the electronic version of a printing press. They can and this is the way Bernanke described it in 2002 when he said that “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

However more often printing money means that the Federal Reserve will hold an auction to buy assets like bonds or mortgage backed securities from banks. Then they issue a credit to the bank’s account, creating new money and the hope is that the bank will use the money to lend to businesses and consumers.

Unfortunately by increasing the supply of dollars, each dollar is worth less. The U.S. government also increases its debt burden, raising concerns for foreign investors. This is compounded by the fact that the Fed’s purchases of Treasuries will drive down bond yields, reducing the attractive of dollar denominated investments.

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