FX Weekly Preview: FOMC Highlights Big Week

Eurozone

The days ahead are historic. By all reckoning, Merkel will be German Chancellor for a fourth consecutive term. Many observers expect the election to usher in a new era of German-French coordination to continue the European project post-Brexit and in the aftermath of the Great Financial Crisis.

A reanimated European project is also informed by a sense that America may be a less reliable partner, and a strong Europe is needed to secure the gains of multilateral institutions and the rule of law. Although Kohl also served four terms as Chancellor, and oversaw the reunification of Germany, Merkel plays a critical role in shaping Europe.

Economic Events: Eurozone, Week September 18

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United Kingdom

At the end of the week, UK Prime Minister May is expected to deliver one of her most important speeches about Brexit. Expectations are so high that the next round of UK-EU negotiations was postponed to give May this opportunity. She is expected to present a vision of the post-Brexit relationship between the UK and Europe. It will be grist for op-eds, but will do little to push negotiations forward, which are still stuck on the terms of the separation. UK officials seem to resist the notion of sequencing on which the EU negotiators insist.

Neither sterling nor UK asset markets are being driven by Brexit. Sterling rallied nearly 3% last week to brings its gains here in September to 5.1%, the best in the world. The main driver was surprisingly hawkish MPC minutes. There have been several times over Carney’s tenure as Governor that the BOE has sent such a signal to the market. It has not delivered, but of course, this time, like every time could be different.

Here in Q3, the Bank of Canada has taken back the two rate cuts it delivered in 2015. It provided accommodation to help the economy through a transition. It judged that the economy no longer needed that accommodation and removed it. The Bank of England cut rates as part of its precautionary measures after last year’s referendum. It is not unreasonable to judge that that accommodation is not required.

Alternatively, Carney can do what he has successfully done before: Show a pragmatic flexibility and trust the data. It is not unreasonable to expect last year’s currency depreciation to have nearly run its course, and for price pressures to peak shortly. The market will likely be particularly sensitive to the UK’s high frequency data in the coming weeks, as the BOE is perceived to be as well.

Economic Events: United Kingdom, Week September 18

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Japan

Three major central banks meet in the week ahead: Norges Bank, Norway’s central bank, the Bank of Japan, and the Federal Reserve. Soft inflation data last week underscore the Norges Bank is on hold. The Bank of Japan is also not expected to change policy. The BOJ does not need to buy JPY80 trillion of JGBs a year to keep the 10-year yields in a 10 bp band around zero. Some see this as evidence of stealth tapering. We are not convinced that this is the best way to understand what the BOJ is doing, but we recognize the BOJ has been reluctant to formally acknowledge this by scaling back its announced target.

Economic Events: Japan, Week September 18

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United States

In any event, the FOMC meeting will be historic.  We have been suggesting since June that the Federal Reserve would announce the beginning of its balance sheet reduction at the September meeting. Although the BOJ had been engaged in preliminary forms of quantitative easing, the Federal Reserve codified it, elaborated on it early in the Great Financial Crisis.  Although there were several rounds, it did cease, despite the mocking by the skeptical that, once begun, it would be impossible to stop, as in QE-infinity.

The Fed has not only stopped, but it is in a position to begin to generally unwind some of it.  The unprecedented nature of what is about to happen seems to be under appreciated by many investors.  Of course, other central banks will not simply follow it, they will elaborate and modify according to idiosyncratic factors, pre-existing conditions, and institutional arrangements.  However, the Fed’s conduct will be part of the information set they will have that the Fed does not.

The Fed has made clear how and at what pace its balance sheet will shrink.  It will simply not recycle the full amount of maturing bonds and MBS in its portfolio.  It seeks to put the program on near automatic pilot; not to be influenced by the vagaries of the economic data or the proximity to its goals. The pace will begin slowly at $10 bln a month ($6 bln Treasuries and $4 bln MBS). The pace will increase by $10 bln a month every quarter until reaching the $50 bln a month.  We suspect in the initial period the market impact will be minor, but as the terminal velocity of $ 150 bln per quarter is approached,  the risk of disruption seems to be greater.

Admittedly there are a number of moving parts and imponderables, like the Treasury’s issuing schedule, fiscal policy, global development, and the regulatory treatment of Treasury assets for financial institutions.  Tax considerations and investment strategies that have led to vast amounts of cash on corporate balance sheets (a recent Financial Times report found that 30 US companies had accumulated a combined portfolio of cash and financial assets worth more than $1.2 trillion) are also important factors in trying to anticipate the impact of the shrinking of the central bank’s balance sheet.

The Fed’s main tool for monetary policy will remain the Fed funds target (range). A September rate hike has long been ruled out by investors, with guidance by the Fed officials.    Investors ought not expect any clues for the December FOMC meeting, the next one that is followed by a press conference. Shaping expectations for the December meeting can wait until at the November 1 meeting.

Economic Events: United States, Week September 18

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Switzerland

Economic Events: Switzerland, Week September 18

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