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

Fed rate hike Federal Reserve FOMC forex blog Kathy Lien US Economy

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.

FOMC_0416

<table>

Fed: Data Shows Mkt Pricing in Q2 Rate Hike?

2010 japanese yen forecast 2011 british pound forecast 2011 cad forecast 2011 dollar forecast 2011 euro forecast Bank of Canada Bank of England Bank of Japan Bernanke Fed rate hike Federal Reserve forex blog Kathy Lien

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

2009 us dollar forecast 2011 dollar forecast Fed rate hike Federal Reserve Kathy Lien

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.

100bp of Tightening Priced in for ECB?! See Latest G7 Rate Hike Expectations

2011 british pound forecast 2011 cad forecast 2011 euro forecast aud/usd Australian Dollar australian dollar forecast ECB ecb rate hike Fed rate hike Federal Reserve forex blog Kathy Lien

Rate hike expectations are always changing and its important to keep track of them because they reflect what investors are pricing in.

Here are the latest numbers and highlights (compared to last week)

Fed -- One 25bp rate hike expected by Q1 2012 > Minor increase in implied policy changes
BoE -- 50bp rate hike priced in for this year > compared to only 25bp last week
ECB -- Nearly 100bp price in for this year compared > compared to only 50bp last week
RBA -- Rates expected to remain unchanged this year
RBNZ -- One rate hike in March 2012 down > no changes
BoC -- 50bp by Feb > increase in rate hike expectations compared to last week

Comparing the March and Jan FOMC Statements

2011 dollar forecast Fed Rate Cut Fed Rate Cut Expectations Fed rate hike Federal Reserve forex blog Kathy Lien

Compare the changes made to March FOMC statement with the Jan one.

FOMC Statement January 26, 2011

Information received since the Federal Open Market Committee met in December confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions. Growth in household spending picked up late last year, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, while investment in nonresidential structures is still weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Although commodity prices have risen, longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

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 for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Forex: Major Changes to Rate Hike Expectations

2009 british pound forecast 2010 dollar forecast Australian Dollar Bank of Canada Bank of England British Pound Canadian Dollar ECB eur/usd Fed rate hike Federal Reserve Kathy Lien

Over the past 3 weeks, central banks around the world have made a number of comments that have affected rate hike expectations. On Jan 27th, I showed where rate hike expectations were at the time and since then a number of interesting changes have occurred.

First, the market is now pricing in a 25bp rate hike by the Fed in Dec. Last month, no rate hike was expected. Close to 70bp of tightening is now expected from the Bank of England, up from 50bp. The market went from pricing in 2 rate hikes from the Reserve Bank of New Zealand to one. The European Central Bank and the Bank of Canada are now expected to tighten by 75bp this year instead of 50bp. A lot can change in 3 weeks =)



Comparing the FOMC Statements – Jan 2011

Fed rate hike Federal Reserve FOMC Kathy Lien

Curious about the changes in the FOMC statement? I did the work for you and highlighted the ONLY things that changed from December and whether it constituted an upgrade or downgrade

FOMC Statement December 14, 2010

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment (offsetting changes). Household spending is increasing at a moderate pace (an upgrade!), but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. The housing sector (from housing starts) continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November (just an adjustment of words to accommodate Nov announcement). The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

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 for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Voting against the policy was Thomas M. Hoenig. In light of the improving economy, Mr. Hoenig was concerned that a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.

Fed Announcement – Four Possible Scenarios

2010 dollar forecast dollar rally Fed Rate Cut Expectations Fed rate hike forex blog Kathy Lien

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)