Global Markets Research
Foreign Exchange: Strategy
19 September 2013
The Fed chose not to taper its monthly asset purchases. We expect tapering to begin in December 2013.
We have not changed our view the USD is starting a multi-year uptrend, though the USD will be softer for a while longer.
In line with our previous guidance, we retain our recommendation to buy dips in USD/JPY below 98.0.
Wait and see
The Fed did not taper its asset purchases as most analysts and market participants expected at its September meeting. Unsurprisingly, the USD slumped, US 10 year swap rates decreased by 16 basis points to 2.81% and the S&P 500 lifted by 1.2% to a record high (chart 1).
The Fed chose to keep its asset purchases at US$ 85 billion per month because it judges: (i) US economic data is not yet strong enough; (ii) financial conditions have tightened; and (iii)Federal government fiscal policy is restrictive and may become more restrictive, depending onupcoming fiscal debates in Congress.
The Fed wants to “await more evidence that progress will be sustained before adjusting the pace of purchases”. We see the Fed’s decision to not taper asset purchases as a delay of the inevitable.
In our view, the Fed has a ‘wait and see’ stance. The Fed will wait to assess the US economic data. In particular, they will be interested in evidence that the recent tightening in financial conditions, such as the steep increase in mortgage interest rates, has not derailed the economic recovery. The Fed also appears to want to wait for the US Congress to deal with outstanding fiscal policy issues such as the continuingresolution to fund the government and increase the ceiling on government debt. We expect both the continuing resolution and the debt ceiling to be dealt with by the middle of October.
The Fed’s balance sheet will continue to expand at a rate of US$ 85 billion per month for the next few months. Even if the Fed had chosen to taper its asset purchases at the September meeting, the Fed’s balance sheet would still be expanding, albeit a slightly slower rate.
According to Fed officials, every US$1 trillion increase in the Fed’s balance sheet is equivalent to cutting the long-term term bond premium by 50 basis points. By Q3 2014, we estimate the Fed’s balance sheet will increase to around US$ 4.4 trillion, assuming tapering begins in December 2013. Under our old assumption, the Fed’s balance sheet would have increased to around US$ 4.1 trillion by Q3 2014 had tapering started in September. The difference in the size of the Fed’s balance sheet under these assumptions is only US$ 0.26 trillion or about 13 basis points on the term premium (chart 2). It does not matter greatly whether the Fed’s monthly asset purchases are $US 85 billion or $US 75 billion. The Fed’s balance sheet is still very large, still expanding and supporting the US economy.
The Fed neither changed the funds rate nor its forward guidance on the funds rate. Most Fed members indicated they expect the first increase in the funds rate will occur in 2015 (chart 3).
As indicated above, we think today’s Fed decision not to taper asset purchases as a delay of the inevitable rather than a change in course. We expect the Fed to taper its asset purchases at the FOMC’s 17-18 December meeting. We choose December over the next meeting in October because the December meeting will include a new set of US economic forecasts and Chairman Bernanke will hold a press conference to explain the FOMC’s policy decision.
The Fed is a long way from tightening monetary policy. There are a number of steps before tightening will start (chart 4). We expect the Fed to start tapering asset purchases in December 2013 and stop asset purchases altogether in Q3 2014. We predict the first increase in the funds rate will occur in Q3 2015.
Implications for currencies
While the Fed did not taper its assets purchases, Chairman Bernanke was dovish at his press conference and the USD fell, in line with our expectations.
Our currency strategy is unchanged. We have not changed our long-held view that the USD is starting a multi-year uptrend, though the Fed’s decision will keep the USD softer for a while longer. When it looks like the Fed will taper its asset purchases, US swap rates will lift, pushing up the USD. We still think the Fed will start the monetary policy ‘normalisation process’ before the ECB, BoE, BoJ, SNB and RBA. This should ultimately be USD-supportive.
In line with our previous guidance, we retain our recommendation to buy dips in USD/JPY below 98.0. In addition to our view that the USD is starting a multi-year uptrend, we also consider the yen is in a multi-year downtrend because of the collapse of Japan’s current account surplus. There is a strong chance the Bank of Japan announces more policy easing at its next meeting on 4 October if the Japanese government decides to lift the consumption tax, helping to support further gains in USD/JPY.
AUD may track a little higher today and the following few days as participants react to the Fed’s announcement. By contrast, the RBA prefers the AUD to fall. The more the AUD lifts, the more likely the RBA will look to offset the tightening of financial conditions with a cash rate cut. There is only a modest amount of pricing for RBA rate cuts currently in the OIS curve. The OIS curve may include more pricing for RBA rate cuts if the AUD keeps lifting or the next Australian CPI (released on 23 October) is low. Given our medium term view that the USD will lift, and the Fed’s decision today only delays the inevitable tapering, we do not see a lot more upside to AUD from current levels.
The Fed’s expanding balance sheet contrasts the the European Central Bank’s (ECB) shrinking balance sheet. The decline in the ECB's balance sheet is being driven by bank repayments of the Long-Term Repurchase Operations (LTRO) provided at the height of the Eurozone crisis. The difference between the ECB’s and Fed’s balance sheet has provided a good guide to EUR/USD in recent years (chart 6). Although the correlation appears to have eased recently, the narrowing central bank balance sheet differential, along with the Eurozone’s record current account surplus and the gradual recovery in the Eurozone economy have been key factors supporting the EUR over recent months.
We see risks some of these supports for EUR begin to ease. First, we think there is a chance the ECB provides further policy support, particularly via another LTRO over coming months. There is some concern that the reduction in excess liquidity at the ECB will put undue upward pressure on Eurozone market interest rates. The ECB views higher market interest rates as a downside risk to the Eurozone economic recovery. Second, as the Eurozone economy improves, rebounding domestic demand would boost imports, weighing on net exports. This could limit further increases in the Eurozone current account surplus.
We do not want to overplay the importance of Fed policy for currency direction. We have emphasised recently that Fed policy is only one, albeit important, influence on currencies. Current accounts also matter for how currencies react to changes in prospective Fed policy. Since the ‘taper talk’ started on 22 May 2013, currencies with relatively large current account deficits have generally underperformed currencies with solid current account surpluses (chart 7).