The outcome of Wednesday’s FOMC meeting and Fed Chairman Bernanke’s comments about the economy and monetary policy are widely expected to shape the near-term FX trading outlook.
Currencies and equities are starting off what promises to be a busy week on firmer footing with the US dollar (USD) holding steady or trading lower against all major currencies except the Japanese yen (JPY). The weakness of the yen confirms that risk appetite improved over the weekend as investors turn their focus to this Wednesday's Federal Open Market Committee (FOMC) meeting, the latest Chinese manufacturing PMI report, and Thursday's Eurozone PMI numbers.
While most of the speculation about what the Federal Reserve will say or do centers around the potential for a lower GDP and inflation forecast for 2013, investors don't seem to be fazed by this possibility, as evidenced by US equity futures, which are trading sharply higher.
Once every quarter, the Fed updates its GDP, PCE price inflation, and employment expectations, and this month, most of the leading banks on Wall Street are calling for downgrades because current GDP and inflation trends are weaker than the Fed anticipated back in March. Regardless, we continue to see gradual improvements in the US economy.
For example, according to the Empire State survey, which rose from -1.43 in May to a three-month high of 7.8 in June, manufacturing conditions in the New York region recovered after pulling back last month. This may only be one piece of early US data, but it provides hope for the US economic outlook nonetheless.
The main question this week is what Fed Chairman Ben Bernanke will say about tapering asset purchases and what kind of impact it will have on deleveraging in the FX and fixed-income markets. The past few weeks have been brutal for both of those markets, and considering that a large part of the deleveraging was caused by the reset of monetary policy expectations for the Federal Reserve and the Bank of Japan (BoJ), the key to stabilization this week lies in the hands of the US central bank.
While we still feel that the Fed wants to taper asset purchases this year, Bernanke will go out of his way to distinguish the difference between tapering and tightening. He will also try to reassure investors that cheap and easy money is not going away anytime soon.
If successful, that should mean more weakness for the US dollar and a recovery in high-beta currencies. However, if Bernanke overemphasizes the central bank's plans for tapering, the dollar could resume its rise, leading to a surge in Treasury yields, which would be an unwelcome outcome in the eyes of the Fed Chairman.
Speculation about each of these possibilities will continue to grow and will be a primary driver of FX trading leading up to Wednesday's FOMC announcement.
By Kathy Lien of BK Asset Management