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USD licks post-FOMC wounds

by Ashraf Laidi

The US dollar suffered one of the biggest 1-day declines in nearly two years as the Federal Reserve dropped its pledge to be ‘patient’ in normalizing monetary policy, while downgrading its latest economic forecasts and suggesting it “will not be impatient” in acting on interest rates.

But the greenback is quickly regaining composure against all currencies, as traders look through last night's volatility and reason that a Fed rate hike, however delayed, would be in contrast of what most central banks are doing.

The Fed’s summary of economic projections were downgraded for GDP growth and infation, alongside unemployment. The US dollar index plunged 3% due to a swift repricing of interest rate normalization by currency and bond traders. EURUSD soared to $1.1043 from a low of $1.0580, a rally not seen in recent years.

Downgrading growth and inflation

Central tendency forecasts for 2015 GDP were lowered to 2.3-2.7% from 2.6-3% in December as were those for 2016 GDP to 2.3-2.7% from prior 2.5-3%. Forecasts for 2015 inflation — as measured by core PCE price index was lowered to 1.3-1.4% from 1.5-1.8%. The 2015 view for the unemployment rate was reduced to 5.0-5.2% from 5.2-5.3%.

Median Fed Funds forecast by end of 2015 was reduced to 0.625% from 1.125% and seen at 1.875% by end of 2016 from the prior 2.5% forecast, which remains more hawkish than the rate priced in the bond market. Only 2 of the Fed’s 17 members continue to see no rate hike in 2015.

Why the Fed bothered dropping “patience”?

And so if the Fed signaled such a downbeat view on the economy, why did it bother to remove the “patient” phrase on normalizing rates? The aim was to tell markets it is ready to raise rates as early as this year, but was not in a hurry to do so, and remained bound by further progress in the data, rather than progress in the calendar. The Fed added a new guidance with emphasis on seeing inflation improve. It stated: “…that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.”

Such veiled emphasis on inflation normalization tells us that even if employment has been rising at an average monthly rate of +200K and unemployment well below 6%, it would be inappropriate to raise rates without inflation starting to trend higher towards the 2.0% objective.

About that US dollar

International developments were kept in the FOMC statement since being added in the January statement, referring to the slowdown in China, eurozone and disinflationary dynamics arising from this regions via the strong US dollar. Yellen noted she expected “…net exports to serve as a notable drag” on the economy, mainly due to “recent appreciation of the dollar“. Today’s 3% plunge in the greenback resulted from a hard repricing of interest rate normalization by currency and bond traders, which will slow down the pace of the plunging euro and deteriorating carry costs of Asian (and other EM) investors who owe USD-based loans from their depreciating currencies.

And if you think the Fed’s removal of patience marks a new step closer to hiking rates, you could thing again. In December 2012, the Fed added the guidance of telling markets it would not raise rates before unemployment fell below 6.5%. As unemployment fall neared 6.5%, the Fed said it wouldn’t raise rates until a “considerable time” elapsed following the end of QE3 –or end of asset purchase program. Such time was suggested to be 6-9 months. Once the Fed completed bond purchases in December, it said it would be “patient” about raising rates. Now that “patient” is gone, the Fed has reverted to a general statement about unemployment and inflation.

USDJPY-WEEKLY-Mar-18-2015

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