- Key feature of today's FOMC rate decision will be whether or not the balance sheet normalization process commencement is announced; if so, the US Dollar may find some desperately needed support.
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The most important event of the week for the US Dollar - and all of FX markets - comes today when the Federal Reserve meets for its September policy meeting, one of the four meetings per year that produces a new summary of economic projections (SEPs) containing the infamous 'dot plot,' as well as a press conference from Fed Chair Janet Yellen. As it were, the Fed, like the ECB, BOE, and RBNZ, in an effort to become transparent, has become predictable: they will only make a major policy change (i.e., hike rates) with justification in hand and an opportunity for Chair Yellen to explain to markets why they made their decision.
Today's meeting will not bring a rate hike, however. Fed funds futures are pricing in exactly a 0% chance of a 25-bps rate hike after all. Accordingly, whether or not the Fed uses this meeting to announce the implementation of their balance sheet normalization strategy, which was outlined at the June meeting in the “Policy Normalization Principles and Plans” augmentation.
The Fed intends to wind down its balance sheet with an initial reinvestment cap for US Treasuries at“$6 billion per month initially, and will increase in steps of $6 billion at three-month intervals over 12-months, until it reaches $30 billion per month.For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.”
Effectively 'quantitative tightening,' the balance sheet unwind will be the withdrawal of stimulus from the US economy. Given the underlying instruments - Treasuries and agency mortgage-backed securities - it would appear that a balance sheet unwind announcement should help buoy long-end US yields. In turn, widening interest rate differentials and a steeper yield curve, over time, should help the US Dollar stabilize and break its 2017 downtrend.
Should the Federal Reserve’s September policy statement reveal the beginning of the normalization process and a reaffirmation of the desire to raise rates by the end of the year (in say, December), perhaps market participants will be forced to confront the divergence between what the Fed is saying it wants to do and the much more dovish interpretation that the market currently holds. If so, the US Dollar may just finally find a reprieve after its latest swing lower.
Ahead of the FOMC meeting, it's still too soon to say that a low is in place for the US Dollar on a broad basis. The DXY Index tested its daily 21-EMA last week, only to fail to close above it; it hasn't closed above its daily 21-EMA since June 22. Aside from the daily 21-EMA (now at 92.28), traders may want to wait for further confirmation for a DXY Index low until the August 25 bearish outside engulfing bar is cleared out at 93.44.
--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
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