Most of the major currencies continued to consolidate ahead of FOMC but in a few hours, volatility should pick up quickly and aggressively. At 2pm ET / 19 GMT, we will learn if the Federal Reserve thinks it is time to start tapering asset purchases and shortly thereafter we will be listening for their forward guidance. Post FOMC trades should not be placed until the Fed's forward guidance is clear. Over the past few days, we have written various pieces about what to expect from the Fed and how it could impact the dollar. Today, we are compiling all of those views into one report to give our readers a thorough preview of the FOMC meeting.
Over the past week, the dollar appreciated against many of the major currencies but the gains have been small. Since the surprisingly strong labor market numbers, the dollar strengthened against the AUD, GBP and NZD but weakened against the EUR, JPY, CAD and CHF. This price action reflects the level of uncertainty and lack of conviction for the central bank's actions this month.
The decision to taper or not to taper is a close one. For the Federal Reserve, the greatest motivation for December tapering is the strength of U.S. data. Since the last FOMC meeting, we have seen a significant recovery in consumer spending and the labor market but there are still pockets of weakness in other parts of the economy. To get a sense of what the central bank could do, lets start by putting ourselves into the shoes of the Fed by looking at how economic data has changes since the last FOMC announcement on October 30th. Non-farm payrolls averaged 204k over the past 4 months and this strength drove the unemployment rate down to 7%. Retail sales also rebounded in November after contracting in September and according to the latest consumer sentiment survey, Americans are feeling more optimistic. Unfortunately housing market activity has been uneven, inflation is low and while manufacturing activity accelerated, service activity slowed. Strong arguments can made to wait or to press forward with tapering.
With USD/JPY and the EUR/USD hovering right below multi-year highs, the big question on everyone’s minds is which direction these pairs will move after Wednesday’s FOMC announcement. We have seen USD/JPY and EUR/USD rise simultaneously when stocks responded positively to the non-farm payrolls report but the FOMC announcement is significant enough that we could also see a uniform reaction in the dollar. It all boils down to how clearly Ben Bernanke lays out its plans for ending Quantitative Easing before he leaves office. While it may be exciting for the outgoing Fed Chairman to outline his vision for ending a program he started in 2008, he won’t be the one that has to deal with the consequences of withdrawing stimulus too slowly or quickly. It is important to remember that when it comes to the FOMC decision, one of the top priorities of the central bank is minimize the volatility from their announcement. This is the whole function of the press conference – to explain their decision and manage expectations so Bernanke’s comments will be just as important as the decision on tapering.
Our base case scenario is for a small amount of tapering this month ($5 to $10 billion) followed by a noncommittal outlook for further reductions that would minimize the market’s reaction and give Janet Yellen the flexibility to design her own strategy for unwinding stimulus. Here are the 4 highest probability scenarios for tomorrow’s announcement and their potential impact on the dollar.
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