Will the FOMC Minutes End Dollar's Correction?

Corrective forces continue to grip the foreign exchange market.  Many expect the dollar's downside correction/consolidation to end today.  Technically-inspired short-term participants often see 3-4 day counter-trend moves to be typical of market moves.  Fundamentally-inspired traders expect the FOMC minutes, which will be released in the North American afternoon, to be read by the market participants with a hawkish bias.  

We are sympathetic to a hawkish read of the FOMC minutes, but do not believe that it reflects policy.  Specifically, we argue that the FOMC minutes increase the noise to signal ratio by being comprehensive.  The FOMC minutes, like the dot-plot forecasts makes it seem as if all views are equal.  They are not.  We understand the signal of Fed policy to be generated by three officials:  Yellen, Fischer, and Dudley.  Their main instrument, in addition to their speeches, like Dudley's yesterday, is the FOMC statement. 

Recall that the FOMC statement contained three key points:  First it characterized the slack in the labor market as significant.  One may want to argue that this has been superseded by the recent jobs report that saw the unemployment rate fall below 6%.  However, Dudley repeated that characterization yesterday.  

Second, there is the "considerable" period of time between the end of asset purchases and the need to hike rates.  Dudley again indicated that expectations for a rate hike in mid-2015 are "reasonable".  That suggests a rough definition of "considerable period.  

At the end of the FOMC statement there is a third piece of forward guidance.  Even after the inflation and unemployment are consistent with the Fed's mandates, economic conditions may warrant a lower Fed funds rate than officials would regard as the long-term equilibrium rate. 

At the September FOMC meeting, there were two dissents.  The dissents were not over policy.  It was over words, and specifically, how the forward guidance was provided. Dissenter Fisher from the Dallas Fad was quoted recently indicating he favored a Q1 15 rate hike.  Leaving aside the temporal target rather than macro-economic conditions, the difference between his view and Dudley's (and we say the Fed's Troika view) could be as small as a few months.  The FOMC meetings in Q1 15 are in late January and mid-March.  The Q2 15 meetings are in April and June.  

Although we played down the fundamentals driving the dollar's heavier tone so far this week, we do, of course, recognize the decline in US yields.  The yield on the US10-year note has slumped back toward the year's lows set in mid-August near 2.30%.  It is now changing hands near 2.33%.  It had traded above 2.60% in mid-September.   There are several drivers here.  First, many are citing the weakening of the world growth outlook.  The IMF revised down its global growth forecasts.  Yet, this is due to the timing of its meeting, not that it presents new news.  The OECD previously cut its growth forecasts.  At the same time, the poor German industrial production figures and the HSBC Chinese services PMI (53.5 from 54.1) weigh on growth sentiment.  

Second, and related, is the sharp decline in commodity prices, led by the new multi-month low in oil prices.  The conventional wisdom is emphasizing the weakening demand side.  However, we often find that supply shocks are more important than demand shocks.  That is to say, oil output still seems to be open spigot, and there appear to be bumper US crops.    We also note that although oil prices continue to fall, the CRB index itself bottomed at the end of last week, when the dollar also closed just below JPY110 and the euro was near $1.25. 

Third, we note that there has been strong demand for US Treasuries from both domestic and foreign sources.  In the foreign exchange market, there has been increasing talk that a significant weigh on the euro has been coming from reserve managers.  The IMF's COFER data that were released at the end of September did show that reserve managers reduced euro holdings in Q2, the same time speculators in the futures market were shifting from a net long to a net short position.   

Data included in the Japanese August current account figures, released earlier today, showed Japanese investors continued to buy US Treasuries.  They bought JPY877.5 bln (~$8 bln) of US bonds in August, which brings the year-to-date purchases to JPY3.51 trillion.  This contrasts with sales of JPY5.83 trillion in there first eight months of 2013.  

In terms of domestic buyers, we continue to see signs that US banks continue to accumulate.  Could this be the overlooked carry trade ?  Rising bank deposits, which cost banks practically nothing, are lent to the US government. 

In addition to the FOMC minutes, the decline in oil prices and US yields, a third issue today is the start of the US Q3 earnings season with Alcoa's report after the close the markets today.  Earnings expectations for the S&P 500 have been trending lower, and FactSet now puts them at 4.5% with a 3.7% increase in sales.  In Q2 earnings rose 7.3% on a 4.4% increase in sales.  

Nearly half of the S&P 500 revenues are derived from foreign sales, and there is some concern that the sharp dollar rally will hit earnings.  Some analysts attributed the recent 7.7% decline in Alcoa shares to be driven by concern about the dollar's impact.  Still we note that the shares are still up a little more than 50% year-to-date.   In addition to the dollar's appreciation, there is also the sharp decline in commodity prices that can impact various S&P sectors.  We are suspicious of mechanical models that go from the change in the euro to drop in S&P earnings.  It does not take into account various corporate hedging strategies, or that part of foreign sales that are transacted in US dollars.