The U.S. dollar held onto gains against its global peers Wednesday ahead of Minutes from the Federal Reserve that are expected to confirm the bank’s recent signals on slower rate hikes and a more patient approach to monetary policy in the face of uncertain economic growth at home and notable weakening around the world.
Minutes from the Fed’s January meeting, which ended with no changes to its key lending rate and a removal of a reference to the direction of future decisions, marked the formal confirmation of the Bank’s policy u-turn from its hawkish stance on rate hikes in early December that sent U.S stocks to the lowest levels in 18 months.
The Minutes “should provide some color to the decision taken by FOMC to change its forward guidance and provide some clarity on future balance sheet operations,” said analysts at Maybank. “We do not expect any change in Fed’s dovish-leaning rhetoric. Much softer than expected US data validated Fed’s pause in tightening cycle and the case for USD strength to wane.”
“However we also caution that the risk of further gains in oil prices (possibly due to supply-disruption or material progress on US-China trade deal) could translate into higher US inflation and is supportive of the dollar,” the bank added.
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CME Group futures, which attempt to measure the probability of future rate moves, are now pricing in less than a 2% chance of higher Fed Funds rate between now and next year, with traders now betting on a 20% chance the Chairman Jerome Powell and his colleagues will cut rates from the current 2.25% to 2.5% range by January 2020.
What may prove more important for market participants today, however, is what the Minutes reveal about discussions surrounding the Fed’s $4 trillion balance sheet and the pace at which it allows bonds in the portfolio to mature without being replaced with new Treasuries.
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The so-called balance sheet run-off has acted as an anchor for longer-term interest rates, according to come analysts, and supported the U.S. dollar even as investors trim bets on future rate hikes.
New York Fed President John Williams, who also acts as Vice Chairman of Fed’s Open Market Committee, suggested to Reuters Tuesday that run-off could continue until at least next year, while Cleveland Federal Reserve President Loretta Mester said the run-off could halt before the end of this year.
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Williams also told Reuters that he thought “monetary policy is where it should be … it’s around my view of what neutral interest rates are.”
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Benchmark 10-year U.S. government bond yields were marked 1 basis point lower at 2.636% in early trading Wednesday, while 2-year notes were seen trading at 2.489%, putting the slope of the so-called yield curve at just 15 basis points.
The Fed’s signalling on both rate hikes and its balance sheet normalization are important for equity markets as earnings growth slows and the strong dollar blunts the value of overseas profits for S&P 500 companies.
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If the Fed were to continue reducing its balance sheet well into next year, a pace which would trim its portfolio by around $600 billion, the dollar would continue to hold gains against its major currency peers, many of which are now influenced by dovish central bank signals triggered by slowing domestic growth.
Peter Praet, the chief economist at the European Central Bank, told a conference in Frankfurt Wednesday that he and his colleagues will likely discuss launching another targeted bank lending program next month, a move that would effectively negate any chance of a broader rate hike from the ECB until at least 2020.
“We expect the FOMC Minutes today to reiterate the cautious message from the surprisingly dovish January Federal Reserve meeting (special focus will be on the Fed balance sheet debate), in turn helping EM and G10 FX high yielders,” said ING’s Chris Turner. In contrast, the low yielding segment such as the euro and Japanese yen should continue to lag.”
The Fed’s policy U-turn has also clearly supported American equity markets — the S&P 500 is up nearly 11% so far this year — it hasn’t taken any steam out of the U.S. dollar, which has extended gains against a basket of its six global peers to gain just under 2% fro the year to date.
