Morning Brief – Baby steps

Baby steps

The Federal Reserve Bank offered its latest monetary policy decision yesterday. The announcement from the central bank fell broadly in line with the market’s expectations with Chairman Powell noticing progress in the international economy, but not quite the kind of domestic ‘substantial further progress’ required in order to justify fiddling with the bank’s core policy instruments. Asset purchase programmes across treasuries and mortgage-backed securities shall therefore continue to burn through $120bn of balance sheet invented cash each month. Despite the statement coming in broadly in line with market expectations, the Dollar retreated by approximately one half of one percent across the board. This was likely down to a cocktail of four reasons:

Out of the money interests

Despite the market consensus for no policy adjustment and a rhetorical confirmation of further economic progress, there was an increasingly large tranche of the market betting on more from the Fed. Open market interest, as reported in weekly CFTC data, confirmed the evolving stance of the speculative arm of the market with respect to the US Dollar. The option market too has seen an increasing number of now out of the money strikes left in place to benefit from a more hawkish Fed. The dismissal by the central bank of these expectations, and the cautious but mildly optimistic tone it chose to take instead, forced some of this market interest to be taken off the table in a short by significant long squeeze.

Labour market comments

Speaking on when the conditions for ‘substantial further progress’ could be deemed to have been met, the Chairman of the Committee addressed the labour market:

‘I would want to see some strong job numbers’, Powell said.

Whilst strong is far from a numerical condition for a Friday non-farm payroll statistic or a labour market survey outcome, it was an indication to the market that (un)employment is on Jay Powell’s mind. Labour is often one of the slowest-moving economic factors of production to adjust to an economic recovery due to the inherent frictions associated with job creation. This comment could be responsible for pushing policy normalisation expectations further down the road, weakening the Dollar.

Treasury – Cash swap

Whilst marginal, the Fed did introduce two new permanent facilities within its arsenal of monetary instruments. These facilities allow domestic and foreign eligible market participants to swap treasuries and other less liquid (short-term) forms of money for cash itself. Real money flows within the FX market are often created by a requirement for cash funding in an alternative currency. As a result of these permanent instruments, demand for USD cash could be constrained by the alternative funding now allowed in exchange for short-term quasi-cash instruments. This could limit USD-buyers from the FX market who may chose to fund their cash requirements with the Federal Reserve directly instead.

Risk adjustment and commodity currencies

Overall, yesterday’s decision had been the focal point of the economic calendar for at least this week and perhaps month. In itself it therefore represented a significant risk for markets. It’s relatively smooth passing and cautious outlook opened the door to stronger risk appetite. Under such conditions commodity currencies outperformed making ground against the US Dollar, highlighting its decline.

Discussion and Analysis by Charles Porter

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