The reaction to the July FOMC meeting minutes was less extreme than many predicted, perhaps because the outcome—the Fed remaining on track to taper QE this year—was already priced in.
The broad-based selloff in the US dollar (USD), rise in Treasury yields, and decline in stocks indicates that financial market participants all interpreted the Federal Open Market Committee (FOMC) meeting minutes in the same way and that there is growing evidence the Federal Reserve will reduce asset purchases this year. In fact, the minutes showed broad support for the current tapering timeline, and we know that Fed Chairman Ben Bernanke wants to begin the process before he hands over the baton to his successor.
However, the reaction in the financial markets—and particularly in currencies—was quite slow, and the reason was because investors have already had plenty of time to position for tapering. Further, the recent jump in bond yields suggests that the move had already been priced in.
For the past month, it was not a question of if, but a question of when the Fed will taper, so while we did see the dollar rise, stocks fall, and ten-year Treasury yields extend to new highs in reaction to the FOMC minutes, the moves were restrained.
How the Fed will taper, the amount of purchases that will be reduced, and the guidance about the plans going forward are all still up for discussion and can be used to temper market expectations and potential reactions. Given the recent deterioration in US economic data, we continue to believe that the changes will be incremental.
Nonetheless, the FOMC minutes showed the central bank growing more comfortable with the idea of tapering asset purchases. While a few FOMC members urged patience, others favored tapering soon—and that was back in July.
At the time, policymakers felt that the markets had tightened significantly, and they were confident that a rate hike would not hurt the housing market, which is currently strengthening. They noted that June payrolls, which increased by 195k, represented solid gains, and the Fed expected consumer spending to pick up in the second half of the year, leading to a stronger recovery.
Regarded Fed watcher Jon Hilsenrath felt that the minutes were a tad more pessimistic, primarily because some members felt less confident in the economic growth outlook even though the official forecasts are quite strong.
There's no question that the Fed and the investment community in general should have doubts about the outlook for the US economy, but as long as there isn't a sharp deterioration between now and the September 17 FOMC meeting, the central bank is still on track to taper. Even if the move isn’t made next month, it would then happen in December, and while this prospect hasn't reinvigorated the dollar rally, it should continue to keep the currency bid.
By Kathy Lien of BK Asset Management