- Time to moonlight as a Fed Kremlinologist - word choice matters.
- Fed is very close to setting itself up for a policy mistake in March.
As we approach the January FOMC meeting this afternoon, I'm reminded of a passage from a collection of English short stories I read when I was a boy:
“I can never bring you to realise the importance of sleeves, the suggestiveness of thumb-nails, or the great issues that may hang from a boot-lace.” - Sir Arthur Conan Doyle, The Adventures of Sherlock Holmes.
Here, the good detective implores that 'you' pay attention to the little things in life. Or, as the proverb has been more commonly stated since the mid-20th century, 'the devil is in the details.' Indeed, despite lamentations from those in ivory towers, it may be best to moonlight as a Fed Kremlinologist today - someone who obsessively pours over each word in the policy statement in order to decipher the Fed's next move.
While a tedious task, the devil is in the details: the Fed chooses its word choice carefully, and will inevitably reveal its core belief about its policy path moving forward. Of course, this is the point of consternation for market participants right now, with the Fed talking up the possibility of four rates hikes this year while Fed funds futures are only pricing in one. Over the next few months, depending upon what is said today, the highest volatility scenarios would evolve if the Fed didn't do what it said it intended to do: either saying it still plans on raising rates in March, then doesn't; or it says it may not raise rates in March anymore, then ultimately does.
Given the divergence between the Fed's projected rate path and current market expectations, someone is bound to be wrong, and the repricing will force a major move in the US Dollar: higher if the market needs to price in rate hikes sooner than it currently is; or lower if the Fed backs off its intended four rate hikes path.
We know that the Yellen-led FOMC has had difficulty choosing the correct phrasing to describe its policy path in years past, as recently as what happened from Q4'14 through Q2'15. Chair Yellen stated that it would be around six months after QE ended for when the first rate hike would come, so when it didn't in March 2015, the USDOLLAR Index ultimately suffered. Should the Fed stick to its current path then not raise rates in March, for example, then the USDOLLAR Index may face a trading environment analogous to March-May 2015.
Accordingly, given the nature of today's meeting - despite only being a policy statement release, markets will inevitably begin pricing events down the line - it seems that the current "risk on/off" nature of markets caters to a uniform response along commodity currency/safe haven currency lines. Seeing as how anything USD-positive would likely be risk-negative, it's likely that the Japanese Yen, and to an extent, the Euro, react similarly to the US Dollar today. As a result, the better gauges of risk sentiment today are AUD/JPY and GBP/JPY, not EUR/JPY and USD/JPY.
Ultimately, it seems the safer path for the Fed is to stick to its previously intended glide path while highlighting the downside risks afoot in the global economy. Anything more dovish than that seems bound to set up the US Dollar for a very volatile next few months while throwing the Fed's credibility into question.
Be sure to join me and Currency Analyst James Stanley on Friday, January 29, at 09:00 EST/14:00 GMT for a special webinar discussing the ongoing slide in energy prices and their impact on FX markets.
--- Written by Christopher Vecchio, Currency Strategist
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