Ahead of the FOMC Meeting – September 19, 2017

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.

FOMC Meeting

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.

Conclusion

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.

Euro and the ECB

Yesterday’s ECB (European Central Bank) meeting was the main event of the week. All eyes were on Draghi and the monetary policy conditions to be announced.

As such, the Euro was in focus starting with Monday. And, it didn’t disappoint.

For the whole summer, the EURUSD pair moved in an almost vertical line. It rose from 1.05 to 1.20 in less than five months.

Euro

While such moves are not uncommon in the Forex market, they’re not that common for a dollar pair. Many traders tried to fade the move and sold new highs. However, new buyers stepped in on each and every dip.

But why would the EURUSD surge so dramatically?

The Interest Rate Differential

One reason would be the interest rate differential. The only thing is, it should have favored the dollar. Not the Euro.

While the interest rate in the United States rose to 1%, it is still negative in the Eurozone. As such, the interest rate differential should favor the U.S. dollar. Not the Euro.

Yet, the EURUSD pair rose dramatically. The thing is that Forex traders focus on expectations more than on the actual situation.

And, for the whole summer, the signs from the Eurozone economy were positive. Unemployment dropped, GDP (Gross Domestic Product – the total value of goods and services) rose, industrial production as well, PMI’s look good…all signs of a strong and healthy recovery.

Because of that, trader’s expectations grew that the ECB will react. And, that the Fed won’t do anything moving forward.

As such, if the ECB will start tightening the monetary policy (reducing the size of the quantitative easing program), the interest rate differential will shrink. And that’s what drove the Euro higher.

This Week’s ECB Meeting

To many people’s disappointment, the ECB didn’t deliver. Not that traders expected new measures to be announced this week.

But, at least a hint at what’s about to come. Instead, the ECB chose the path of least resistance. Let’s sit and wait and see what will happen.

All bets are now on the October meeting. It is supposed to bring a schedule for the ECB to reduce the bond buying program.

This, alone, is bullish for the Euro. Will send the EURUSD skyrocketing higher. However, only if the Fed won’t change anything. But this is unlikely.

Comes Fed into Discussion

Following the 2008 financial crisis, the Federal Reserve of the United States (Fed), embarked on various monetary policy programs. All destined to ease the monetary conditions.

As a result, the dollar weakened. Moreover, the Fed’s balance sheet increased exponentially.

Now, the Fed started to tighten the monetary policy. It hiked the interest rates four times, lifting it from zero to 1%.

Furthermore, it vowed to start unwinding the balance sheet. Therefore, it will start selling the bonds in its portfolio.

Of course, this will be a gradual process. But, it has a tightening effect on the monetary policy.

Conclusion

No matter how you put it, the Fed seems to be, again, ahead of the curve. While the Euro buyers base their trades on future expectations, dollar bulls look at what happens with the Fed’s actions.

However, there’s one wild card that doesn’t shows up neither in Eurozone nor in the United States. That’s inflation.

If, when and were inflation will pick up first, that’s where the money will flow. Because expectations will grow that the respective central bank will tighten the monetary policy faster. Hence, the cost of money will rise.