It is All About the Fed

Today’s FOMC meeting is the main event of the week. The focus is of course on the statement. The consensus expects language that underscores its willingness to adopt additional measures if necessary. The discussion about those additional measures has focused on additional Treasury purchases. A Bloomberg poll of 1400 subscribers found that roughly 2/3 thought the Fed was “likely” or “fairly likely” to buy bonds this year and roughly the same percentage thought it would be ineffective. A consensus expects that the bond buying will be implemented incrementally, maximizing the Fed’s flexibility.

The expansion of the Fed’s balance sheet, dubbed QEII, could be justified on the grounds that based on the Fed’s own growth, unemployment, and inflation forecasts, its dual mandate of full employment and price stability is unlikely to be achieved. The Fed has tools at its disposal, few arguably as powerful as its balance sheet.

In some ways the most compelling case for Fed action is that there is an asymmetrical risk in its favor. If it acts and the economic growth picks up in the coming quarters, as Bernanke seemed to suggest as recently as his Jackson Hole speech, the Fed will likely earn praise from investors. That the economy may have recovered without it, would matter little. On the other hand, if the Fed does nothing more than maintain the current size of its balance sheet in the face of weaker inflation suggests monetary conditions and tepid money supply growth suggests monetary conditions may not be as conducive as they might appear.

ECB President Trichet has often said that the ECB does not pre-commit itself. Most of the time, the Fed does not either. If the Fed were to decide that expanding its balance sheet was necessary it would not wait to implement it.

What is the point? Federal Reserve officials have not prepared the market very well for a move today, but this must be seen as a tail risk today. The constellation of opinions on the FOMC may be a larger hurdle that the lack of preparation. Or to put it somewhat differently, the failure to prepare the market suggests a consensus does not yet exist. It may be difficult to win over the hawks, suggesting that any Fed action will have a dissent. The battle may be won by attrition in that the new Fed officials, when they are confirmed, may tilt the balance.

There may be an FOMC member who wants to take action today. Underscoring the easing bias that Bernanke in effect announced at Jackson Hole may not be sufficient to placate. This suggests there may be a tail risk of a dovish dissent.

The most recent string of economic data suggests that pace of economic moderation as stabilized after the spring and early summer weakness. In particular, the August employment data was stronger than expected and it was accompanied by upward revisions in prior months; retail sales are holding up, and the manufacturing ISM is also consistent with moderate expansion. The Fed could recognize that growth has stabilized albeit at lower levels, and more will be done if needed, recognizing the limits of monetary policy.

One of the key reasons why we have turned more bullish the euro over the last couple of weeks is that the 2-year spread between the US and Germany has widened out in Germany’s favor. At 36 bp today, it is the largest premium since the end of last year. It peaked at about 34 bp in the US favor in late May. It was at 10 bp in Germany’s favor at the start of the month. Anything the Fed says/does that widens the spread, i.e., lower the 2-year yield, will likely be euro positive. In the current environment, even the consensus results may be euro positive.

A retest on the August euro high near $1.3335 is our immediate objective. The implication is also negative for the dollar against faster growing, rating hiking countries, especially Australia and Sweden. The integration with the US may see the Canadian dollar lag on the crosses. The rate differential channel may also see the market’s probe the BOJ’s resolve to curb yen strength.