While there are several key events this week, one rises above the rest: the Federal Reserves’ June policy meeting on Wednesday, and ensuing press conference with Fed Chairman Ben Bernanke. Since the May 22 Congressional hearing in which he said that the QE3 taper could begin at one of the “next few meetings,” financial markets have been pricing in the beginning of end of the Fed’s recent iteration of QE: the S&P 500 has fallen over -5% from its May 22 high at 1687.18; and US Treasury yields have hit their highest levels in 16-months, with the 10-year note yield rising as high as 2.2913% on June 11.
Certainly, in recent weeks, this information has been lost on the USDJPY: the pair hit its lowest level in two months when the USDJPY slid below ¥94.00 on Thursday. And while recent volatility across Japanese financial assets has contributed to the rebound in the Yen, I think that the USDJPY has been perhaps the best true indicator of what the Fed is going to do this week.
While Chairman Bernanke on May 22 indicated that the QE3 taper could begin at the next several meetings, the USDJPY topped shortly thereafter at ¥103.73 and hasn’t sniffed said levels since then. Considering that the USDJPY is particularly in tune with US and Japanese interest rate differentials, given the increased influence of even the smallest moves thanks to ZIRP policies, the decline in USDJPY suggests that the disconnect from credit markets is a misinformation signal; the USDJPY shouldn’t be falling in the face of higher yields. Recent key economic indicators out of the United States can explain this divergence reasonably well.
The Fed’s stated circuit breaker for QE3 is known as “The Evan’s Rule,” which states that QE3 will remain in place until either a 6.5% Unemployment Rate is achieved, or yearly inflation gauges exceed +2.5%. Neither of those are close to being realized right now: the Unemployment Rate is at 7.6% as NFP growth now averages <+200K for three-month, six-month, and 12-month trends; and core inflation is stable at +1.7% y/y, while headline monthly figures suggest that disinflation may be a problem. Neither of these are close to levels at which the Fed would face an immediate need to cut QE3 by its own definition.
Thus, I suggest that the recent uptick in US Treasury yields is a mispricing of a QE3 taper. Certainly, considering how US financial assets have behaved recently – a weaker US Dollar, weaker US Treasuries, weaker US equities – there is room for further dislocation as a significant portion of market participants will need to reassess their standing after Wednesday. While I can’t lay claim to any credit to the forthcoming propositions, I’ve encountered several loose estimates from fixed income analysts that suggest markets are pricing in a reduction of QE3 perhaps to $50B/month, with at least one think tank suggesting a $5B/month taper to ‘test’ how financial markets react may be in order.
Truly, with the economic docket void of any other tier one data releases or watershed central bank meetings, the Fed meeting this Wednesday is monumental in its own right as it could dramatically alter the June trading environment after the Fed’s path becomes a bit clearer. Excess volatility is guaranteed midweek, so if you are unsure about what might happen with the Fed and the US Dollar, proper risk management dictates that it’s best to stick to the sidelines ahead of the heightened event risk, and take a position once the dust settles. Senior Currency Analyst John Kicklighter will be covering the FOMC Rate Decision on Wednesday beginning at 13:45 EDT/17:45 GMT in DailyFX Plus (login required).
Rate Hike Probabilities / Basis-Points Expectations
See the DailyFX Calendar for a full list, timetable, and consensus forecasts for upcoming economic indicators.
06/18Tuesday // 08:30 GMT: GBP Consumer Price Index (MAY)
CONSENSUS: +2.6% y/y; Core +2.1% y/y
PRIOR: +2.4% y/y; Core +2.0% y/y
The key pairs to watch are EURGBP and GBPUSD.
06/18Tuesday // 12:30 GMT: USD Consumer Price Index (MAY)
CONSENSUS: +1.4% y/y; Core +1.7% y/y
PRIOR: +1.1% y/y; Core +1.7% y/y
The key pairs to watch are EURUSD and USDJPY.
06/19 Wednesday // 18:00 GMT: USD Federal Reserve Rate Decision
CONSENSUS: Key rate on hold at 0.25%, QE3 taper <$15B
PRIOR: Key rate on hold at 0.25%, no QE3 taper
The key pairs to watch are EURUSD and USDJPY.
06/20 Thursday // 07:30 GMT: CHF Swiss National Bank Rate Decision
CONSENSUS: Key rate on hold at 0.00%, EURCHF floor on hold at Sf1.200
PRIOR: Key rate on hold at 0.00%, EURCHF floor on hold at Sf1.200
The key pairs to watch are EURCHF and USDCHF.
06/21 Friday // 12:30 GMT: CAD Consumer Price Index (MAY)
CONSENSUS: +0.9% y/y; Core +1.1% y/y
PRIOR: +0.4%y/y; Core +1.1% y/y
The key pairs to watch are CADJPY and USDCAD.
--- Written by Christopher Vecchio, Currency Analyst
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