Where next for USD after FOMC underwhelms?
USD saw some big moves to the north yesterday, with DXY crossing above the psychological 93.00 level having started the day around 92.20.
Much of the move to the north was driven by a less dovish than expected outcome from the release of the minutes of the FOMC meeting back in July.
Let’s talk about the FOMC…
Remember; when a central bank is more dovish than expected, this is a negative for a currency, while when they are less dovish than expected (or more hawkish than expected) this is a positive for a currency, hence the gains for USD.
Going into the release, traders/investors were hoping that at the July FOMC there would have been a solid discussion on the Fed’s intentions to soon adopt even more dovish forward guidance, be that in the form of Average Inflation Targeting or Yield Curve Control. See the quick explainer below to learn what these are…
What is average inflation targeting (AIT)?
Each central bank like the Fed has an inflation target. The FOMC’s is 2% per year. Average inflation targeting is basically saying that over a long period of time, the central bank will aim to average its inflation target, offsetting periods of low inflation by tolerating higher inflation for a few years, for example. In the case of the FOMC; inflation has been consistently below 2% for more than 10 years. If they adopt AIT, this pretty much means they will be comfortable with inflation above 2% for a few years – this is very dovish. In the past, the inflation target has been seen as more of a maximum level, rather than an average target.
What is yield curve control?
This is a way a central bank can support its government by keeping government borrowing costs low. For example, the Reserve Bank of Australia has a policy where it will buy as many 3-year Australian government bonds as is necessary to keep the interest rate at which the government can borrow 3-year bonds at 0.25%. For example, if there is a lack of demand for Australian government bonds and you see their price falling (and the interest rate at which the government can borrow going up), the RBA will step into the bond market and buy as much as is necessary to keep government borrowing costs at the stated target. The FOMC did not seem to like this policy, as explained above.
But the FOMC minutes revealed that, though some policymakers have spoken about the idea of the policy recently, there was no discussion on average inflation targeting.
Moreover, FOMC members did discuss yield curve control, but many members pushed back against the idea, arguing that the policy would bring little benefit and carries downside risks (such as having to buy an unlimited some of bonds if required, and also the fact that it is hard to “ween markets off” YCC when started).
The FOMC did note that more explicit forward guidance was needed, but by the sounds of it, the FOMC prefer to do that by providing outcome or calendar-based guidance, or both. Another quick explainer; outcome-based forward guidance is literally as simple as something like this – “we (the FOMC) want to see unemployment to drop as low as x% and inflation above target for x amount of time, before we consider hiking rates again”. Meanwhile, calendar based forward guidance could be as simple as “we (the FOMC) will not raise rates until at least 2023”, for example.
Moreover, the Fed did note that it has observed that the rate at which the US economy has been recovering has slowed as of late, which is a bit dovish. Net-net, however, the markets seemed to take the minutes release as less dovish than expected.
Returning to USD…
It is worth noting that the FOMC minutes were one factor in USD upside yesterday, but DXY had already completed around 2/3rds of its rally before the minutes even came out. That suggests to me that there was some “positioning” going on. I.e. people taking profit on their (perhaps long-held) USD shorts.
We have known for a while that USD short positioning has been stretched, indicating that the bears might be getting tired.
Today’s price action has been interesting in that USD seems to have regained its intra-day safe haven appeal – markets are risk off today for a variety of reasons including yesterday’s FOMC minutes.
But another reason for today’s risk off is soft US data, which boosted USD. The fact that it is trading like a haven again, rather than finding any excuse to sell of suggests to me we might be in for some more upside before the week is out.
One final consideration; Covid-19 numbers are on the rise in the EU. This is yet to hurt EUR sentiment, but the clock on this may be ticking. The ECB, as suggested in today’s minutes, has already clocked onto the fact that high-frequency economic indicators are slowing down. This is certainly one risk to watch for EUR, and what bad for EUR is goof for… USD!
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