Review of the Fed Policy Meeting: More Downside Risks for USD?

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The Fed left policy parameters unchanged on yesterday meeting but reiterated “whatever it takes” mantra to bring activity back to pre-crisis levels. We know from the post-GFC Central banks’ response that this is typical post-crisis wording which usually leads to depreciation of national currency. In addition, it usually precedes some important policy shifts or announcements (QE start, policy framework overhaul, etc.), which is likely to happen at the September meeting. This is dovish news for USD, as risks are skewed for dovish policy revisions. The candidate for this policy shift is yield curve control, so far tested only by the Bank of Japan.

Pursuing an anti-crisis response since the beginning of March, the Fed was able to restore the normal functioning of financial markets (mainly through suppression of credit spreads), reduce costs of borrowing for some borrowers, in particular for the government (via suppression of government bond yields). The Fed announced yesterday that it extends anti-crisis lending facilities until the end of 2020, repo and currency swaps until March 2021, which, in my view, underlines very important idea – the crisis (in particular, possible liquidity crunch) could only be suppressed, but not defeated. In response, we even saw a slight increase in demand for USD yesterday.

The Fed continues to believe that recovery in activity is largely dependent on the dynamics of spread of the virus. According to the central bank this is the biggest determinant of trajectory of recovery. I think this is a key takeaway from yesterday’s meeting, which suggests that monetary policy remains, in a sense, a function of virus spread dynamics. Yesterday I wrote that consumer confidence in the United States, namely consumer expectations, deteriorated more in those states where the second outbreak was bigger. The Fed’s comment that activity will not fully recover until the virus is defeated is another dose of reality that serves as an ominous warning to stock market buyers.

The Fed also said yesterday that investors should be prepared for a shift in strategy of achieving macroeconomic goals in the near future. The change in strategy may entail changes in how the Fed reacts to positive shifts in the economy, such as inflation pickup. If in 2015 the Fed tried to react preemptively to increases in inflation (by raising rates), then the new strategy may allow a slight overheating – the Fed will not rush to raise rates even if there are signs of acceleration in growth. Of course, this is a dovish shift in policy which will be negative for USD.

Markets are also discussing the possibility that the Fed will start managing long-term market rates (so called yield curve control) and will announce this in September. This is an extreme degree of intervention in the bond market, when the Central Bank announces a price and is willing to buy an unlimited volume of bonds of some maturity at this price. Perhaps this measure will be required so that investors willingly absorb the supply of new Treasury bonds, the issue and sale of which may be necessary to finance the new stimulus package. Without this, there could be a surge in interest rates in the key fixed income market – the Treasuries. Expectations of this is a big factor in the USD weakness, which is likely to growth ahead of the September meeting.

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