How the U.S. dollar trades for the remainder of the year will be largely dependent upon the outcome of Wednesday’s Federal Reserve monetary policy announcement. Over the past 2 weeks, the dollar has strengthened significantly and the central bank’s degree of hawkishness will determine whether the dollar will break its 3 month high against the euro. The sharp moderation in job losses and improvement in consumer spending will cause the Federal Reserve to grow more comfortable with the outlook for the U.S. economy. However there are still plenty of reasons why the Fed may not want to appear overly hawkish and therefore quite a bit of uncertainty rests with tomorrow’s FOMC statement. Although we believe that the Fed will underwhelm, dollar bulls may not need much to be satisfied and therefore any subtle changes to the language of the FOMC statement could affect how the dollar trades. A more upbeat tone by the Fed would be positive for the dollar while skepticism about the sustainability of the improvements in the labor market or consumer spending could reverse the greenback’s recent gains.
The 3 things that investors will be looking for tomorrow will be the tone of the FOMC statement, changes to the discount rate and any plans to end emergency programs. We only expect the bare minimum from the Fed because they realize that at this critical juncture in the U.S. recovery, there are more consequences than benefits to being overly hawkish. Now let’s take a look at these 3 questions in further detail:
1) What will be the Tone of the FOMC Statement?
The Federal Reserve provided very little optimism and very little action when they met on November 4th. At that time, the central bank was weary of a jobless recovery and losses in the commercial real estate sector. They were also mindful of the risks associated with a weak dollar and low interest rates. Since that meeting, the U.S. economy has improved. According to the table at the end of this article, the labor market has taken a turn for the better along with consumer spending and confidence. Inflationary pressures also accelerated, while asset prices increased. However the latest non-manufacturing ISM report indicated that activity contracted last month. Given that the service sector represents more than 70 percent of the U.S. economy, the slowdown is certainly worrisome. The manufacturing sector, which previously led the recovery, is also slowing. Furthermore, less than 36 hours after the non-farm payrolls report was released, Fed Chairman Ben Bernanke gave a speech warning about the risks facing the economy which suggests he is not convinced the improvements are here to stay. Therefore we expect a slightly more hawkish but still very cautious tone from the Fed which should help the dollar extend its gains. However the reaction in the dollar should be tempered by the strong likelihood of the Fed repeating the well worn statement that interest rates will remain “at exceptionally low levels” for an “extend period.”
2) Will the Fed Raise the Discount Rate?
Spurred by an article today’s Financial Times about the upcoming FOMC rate decision, there is now speculation that the central bank could raise the discount rate. In our view this is extremely unlikely because we expect the Fed to first announce plans to unwind some of their emergency measures before taking this relatively bold move. Raising the discount rate, which is the rate that regional Federal Reserve banks lend to commercial banks would carry with it hawkish monetary policy connotations. It also would be at odds with the Fed’s commitment to keep interest rates low and plans to taper off asset purchases. However the fact that the Financial Times has raised this option reflects the growing division within the FOMC. Certain Fed officials are more hawkish than others and we expect the division on monetary policy to increase as the economy continues to improve.
3) Will the Fed Announce Plans to Unwind Emergency Measures?
Given the Federal Reserve’s commitment to slow their pace of asset purchases over the next few months and to complete their program by the end of the first quarter, we expect the central bank to step up their plans to unwind emergency measures. There is a good chance that they will also end other emergency programs and any specifics on this front should also be positive for the U.S. dollar.
What to Expect for the EUR/USD
Although 1.45 is a significant support psychological support level for the EUR/USD, 1.44 is the true technical support as it represents the former breakout point in the EUR/USD back in September. If the Federal Reserve is hawkish enough to satisfy dollar bulls, expect this level to be tested. However if they fall short of market expectations and remains cautious, the EUR/USD could rebound back above the 100-day SMA at 1.4650.
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