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USD Risk Ahead! FOMC Rate Decision Tomorrow



USD Risk Ahead!! FOMC Rate Decision Tomorrow


At 1900BST/1400EDT tomorrow (Wednesday the 29th of July), we get the result of the latest FOMC Rate Decision. Analysts do not expect any big policy changes, with money markets pricing 100% chance that rates will be left unchanged at 0.25%. 


The focus of the meeting is to be on what further accommodation we might be getting from the FOMC in the coming months; be that Yield Curve Control (we know the Fed is looking into this, but many voting members have expressed that they are not yet convinced) or more explicit forward guidance on the conditions the Fed would like to see before hiking rates.


Though the data that we have received since the June 9-10th meeting has been largely better than expected (think strong NFP and retail sales data), the resurgence of the coronavirus in many parts of the US since late June has created new downside risks with many areas forced to reverse the reopening of the economy (Fed officials have expressed concern over this). 


Though the US coronavirus curve is now showing early signs of flattening, the experience during the summer will take a toll on the economy; SEB bank say that “early indicators suggest that the recovery has stalled, or even back-tracked in recent weeks” and that “July and August data may show new temporary declines in activity as signalled in last week’s renewed increase in initial jobless claims.” SEB continue that, “although the decline in the GDP in Q2 (released on Thursday, 30 July) may not be as bad as originally feared, the pace of the subsequent recovery in H2 is likely to turn out to be a disappointment” - a result of the resurgence of the virus. Fed officials know this. Thus, SEB conclude that the statement is likely to repeat that the Fed is “committed to using its full range of tools to support the US economy”.


When the Covid-19 crisis was at its peak, the Fed stepped in with several easing bazookas (such as limitless QE and huge liquidity operations) in order to secure financial market functioning. Having succeeded on that front, the emergency phase of the crisis is now over. The Fed now wants to keep policy as accommodative as possible in order to facilitate the long-term economic recovery. 


The discussion on these further tools of accommodation centre around forward guidance. Note, the reason why forward guidance is seen as so important is because a key lesson from the aftermath of the Global Financial Crisis was that financial conditions tightened too early by not giving strong enough forward guidance, which eventually slowed the recovery – in Sum, the Fed wasn’t aggressive enough in promising markets that rates wouldn’t begin rising as economic conditions improved. Thus, markets started pricing in higher interest rates, even though this wasn’t what the Fed at the time explicitly signalled, meaning that economic conditions essentially tightened without the Fed wanting them to. 


Yield curve control (setting a target yield for US government bonds and not letting the yield move above this in order to keep government financing costs (and broader interest rates low) is in the discussion, but many Fed officials are not convinced yet. More detail on what the Fed would like to see moving forward for rate hikes (i.e. unemployment back below 4% and inflation above 2% for 6 months, for example) is another option.


In terms of financial markets and any potential reaction; the Fed will be very happy in observing how markets are have bought nicely into the low rates for a very long time narrative (markets do not price any rate hikes over the next two years), as well as falling yields on US government debt and a falling USD (which is good for both US exporters and global economic growth). 


They will not want to send any even remotely hawkish signals that might risk reversing these favourable financial market developments, so most do not expect this FOMC meeting to be a USD positive event. Most do expect that further assurance of simulative monetary conditions for the foreseeable future will keep risk assets such as US equities (and likely AUD, NZD and CAD) buoyed, however.

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