Fed will not allow balance sheet to shrink quickly - Westpac

Sean Callow, Research Analyst at Westpac, suggests that the US dollar’s short term outlook remains mostly constructive as rather than delivering a setback to USD recovery, the FOMC provided fuel for further gains.

Key Quotes

“USD is up against all G10 currencies so far this week except for NZD, which bounced on perceived reduced political risk around Saturday’s NZ election.”

“It is perhaps a little surprising that the FOMC statement and forecasts produced such a sharp rise in US yields and the dollar. The steady fed funds rate at 1.0-1.25% was 100% priced in and the October commencement of balance sheet reduction was clearly flagged by even Fed doves such as Brainard. from Oct-Dec 2017, only a net $6bn of treasuries will be allowed to mature (plus $4bn in agency debt and mortgage-backed securities).”

“So while it is a significant step for the Fed to commence what it calls “balance sheet normalization program” and could also be termed quantitative tightening or QT, the very gradual pace set out should mean there is no QT tantrum. Compare for instance the $10bn monthly reduction to the ECB’s EUR60bn QE.”

“It may be that markets were positioned for the FOMC to show reduced enthusiasm for a Q4 2017 rate hike. Pricing for a Dec move had already been on the rise, up to about 60% chance. But it rose to above 70% as the “dot plots” showed that just 4 FOMC members preferred to hold steady through end-2017, unchanged from June despite the recent fall in core inflation.”

“This sets up the US dollar fairly well near term, with negative yield currencies EUR and CHF probably most at risk. EUR/USD could probe the 1.16 handle if the ECB retains its concern over the euro in October, while USD/CHF looks to the 0.98 handle – albeit with the ever-present caveat that markets are not well priced for a rise in risk aversion.”