The Federal Reserve of the United States is about to announce the start of the so-called “quantitative tightening” program. Also known as QT.
It is the exact opposite of the quantitative easing (QE). Under the easing program, the central bank bought U.S. Government bonds. As a consequence, it flooded the financial system with liquidity.
The new program should have the opposite effect. Slowly but surely, it will drain liquidity from the markets.
However, there’s the catch. The Federal Reserve of the United States may be the U.S. central bank. But, when setting the rates on the dollar, it sets the rate for the world’s reserve currency.
The Fed and the Federal Rates
The problem for the rest of the world is that it borrowed massively during the 2008 financial crisis. And, it borrowed in dollars, because the interest rates were down to zero.
Now with the Fed already raising the interest rate to one percent or more, and with the upcoming QT program, the world will experience a dollar shortage.
As such, the dollar should increase in value. That’s the usual effect of a tightening monetary policy. And this one in the United States looks like delivering a double blow to dollar bears.
So far, the markets couldn’t care less. The EURUSD has the 1.20 in view, AUDUSD flirts with 0.8, and the GBPUSD broke 1.36. It even recovered into the Brexit move’s territory.
Monetary Policy Transmission Mechanisms
In a way, this isn’t surprising. The monetary policy transmission mechanisms lag current prices.
The fact that the dollar is so weak is unusual. For the Forex market never expects the actual monetary policy decisions to make their way into the real economy. It’ll act on expectations.
For example, when a central bank becomes dovish and loosens the monetary policy, the currency will react on the spot. Market participants won’t wait for the effects to appear in the real economy. They’ll sell the currency right at the moment the new measures were announced.
What Next for the Rest of the Year?
The world is in limbo. The North Korean showdown puts the JPY on fire, even though it is interesting why the market looks for shelter in a currency that belongs to a country that sees ballistic missiles flying over the population heads. Perhaps the market discounts the North Korean threat.
In any case, the USDJPY looks bullish. If anything, the USDJPY and USDCHF seemed to have been kept at current levels only by the risk off environment lately.
Take that away, and 116, respectively parity are in focus. As for the Euro, the ECB looks to end its quantitative easing program. However, it’ll have a long way until normalizing the monetary policy.
Now that the EURUSD almost broke the 1.21 levels, fewer people favor shorting the common currency. But, if the EURGBP tells us anything, it is not a bullish story.
A higher Euro was the central theme over the summer. It grew against the American dollar and the Great Britain pound, without correcting much. However, summer trading isn’t always relevant for the year. Expect the dollar to fight back, and the current monetary policy differential across the globe might be just the reason for its bounce.