Dollar Broadly Weaker As Fed Keeps Punch Bowl In Place

By Marc Chandler for the BBH Currency Strategy Team

– To put it mildly, the Fed’s dovish surprise has many implications for the market. The first is that the Fed is very concerned about the backup in US rates, and the negative impact on the economy.

– The second major implication is that Fed credibility has taken another leg down

– The December meeting should now be seen as the earliest one possible for tapering

– We think there is a risk that markets get bombarded with conflicting Fed signals in the coming days

– Implications for EM are pretty straightforward over the short-term: buy

Price action: The dollar is broadly weaker as markets continue to digest the implications of yesterday’s dovish surprise from the Fed. The major exceptions are sterling and the yen, as the former was hurt by much weaker than expected UK retail sales (-1.0% m/m vs. flat consensus). EM FX is having a huge up day, the exceptions here being ZAR and TRY. SNB kept policy steady, as expected, while the SARB meets later today and also expected to keep rates steady. Global equity markets are higher. MSCI Asia Pacific is up over 2%, while Euro Stoxx 600 is up nearly 1% and S&P futures are pointing to an up open. Global bond yields are significantly lower on the day across the globe, underscoring just how important Fed policy is to the world.

• To put it mildly, the Fed’s dovish surprise has many implications for the market. The first is that the Fed is very concerned about the backup in US rates, and the negative impact on the economy. So despite market expectations that recent softness in US data would not deter the Fed from tapering before year-end, we find out that that the tapering decision is indeed data dependent. With one month of data unlikely to impress the Fed enough to start tapering in October, that leaves only the December meeting for the Fed to announce tapering before year-end.
• The second major implication is that Fed credibility has taken another leg down. Despite efforts to improve communications and increase transparency, the outsized market reactions (across all markets) after the decision clearly tell us that the Fed still has the ability to surprise us. Indeed, Bernanke in his press conference said that the Fed was so far pleased with market reactions to the FOMC decision, suggesting that at least in this instance, the “failure to communicate” may have been desired. There are good surprises and there are bad surprises. The market reaction so far suggests this was a good surprise, but we think there are potential negative implications down the road. If excesses and “irrational exuberance” build up yet again in the financial markets, the eventual tapering decision may be more painful for markets than it needed to be. We shall see.
• Lower Fed credibility suggests that its efforts at forward guidance may be getting more and more irrelevant. If the Fed (and the market) can’t figure out what the Fed is going to do over the course of 3-6 months, then why should anyone have any confidence that the Fed (and the market) can figure out what it is going to do over the course of 2-3 years?
• Bernanke’s term ends January 31, 2014. That means there are three more meetings with him at the helm: October 29/30, December 17/18, and then January 28/29. We await news over the next several weeks of his replacement. As we said, the December meeting should now be seen as the earliest one possible for tapering. However, now that we know the decision to taper is data dependent, we would posit that if the US economic data remain weak going into the end of 2013, it may no longer be Bernanke’s call for the start of tapering as he may hand off the decision to his successor.
• Despite Bernanke’s efforts to paint this decision as a consensus, we do not think it was. George posted a hawkish dissent, as she “was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.” We think there are others on the FOMC that agree with George in spirit, but did not want to submit an official dissent. Either way, we think that the short-term Fed outlook is quite clear (no tapering likely), but the medium-term outlook just got a lot muddier (start of tapering put off until Fed has more confidence in the economy).
• As such, we think there is a risk that markets get bombarded with conflicting Fed signals in the coming days. After this meeting, we have a huge lineup of Fed speakers coming off the pre-meeting embargo: Pianalto on Thursday (9/19); Kocherlakota, Tarullo, Bullard, and George on Friday (9/20); Lockhart, Dudley, and Fisher on Monday (9/23); Pianalto and George on Tuesday (9/24); Kocherlakota and George on Thursday (9/26); and finally Evans and Rosengren on Friday (9/27). These officials are all over the map policy-wise, so expect some contradictory comments. Interestingly, Yellen doesn’t speak until the Tuesday after next (10/1) at the economic club here in NYC, and this is arguably the most important of them all. Bernanke speaks that Wednesday (10/2) along with Rosengren.
• Implications for EM are pretty straightforward over the short-term: buy. In a sense, EM is rallying over a perceived “stay of execution.” That is, the tapering decision that has hung over EM since May 22 has now been shoved a few months back. As such, we expect EM currencies to continue rallying on this delay. As we alluded to earlier, the day of reckoning may have been made potentially more painful by the Fed’s decision, but for now, EM has room to benefit from continued Fed largesse.