Fed confirms dovish turn

By David Morrison  |  31/01/2019 12:14

Last night the US Federal Reserve declared that it would exercise patience in adjusting the fed funds target rate. It also indicated that it may adjust the rate of reduction of its balance sheet

The US dollar fell sharply last night as investors responded to the latest monetary policy statement from the US Federal Reserve. The central bank kept interest rates unchanged, as expected. However, the Fed changed some of the wording from recent years, dropping language saying that "further gradual increases” could be warranted. The statement now says that the Federal Open Market Committee (FOMC) is adopting a more cautious approach and would exercise patience in adjusting the fed funds target rate, citing “muted inflation pressures” and “global economic and financial developments”.

Balance sheet reduction

Unusually, there was a separate statement which addressed the Fed's balance sheet. This indicated that the FOMC was prepared to adjust the reduction of the central bank's balance sheet should this be warranted by conditions. The statement also indicted that the balance sheet will remain sizable once its reduction is complete. Members said that they expect to operate with "an ample supply" of bank reserves. Some analysts calculate that the Fed may be happy to reduce the balance sheet down to $3 trillion – well above the sub-$1 trillion prior to the financial crisis. The thinking goes that by 2020 currency in circulation will be around $2 trillion. Assuming an “ample supply” of bank reserves is $1 trillion, then that gets the Fed to $3 trillion, meaning a reduction of around $1 trillion from where we are today. If so, and assuming the Fed runs down its balance sheet at $36 billion per month, then it will take more than two years for the Fed to hit its target. This is still a significant amount of liquidity to draw out of the global financial system.

Positive reaction

Nevertheless, investors responded positively to the news as the Fed’s comments suggest that the central bank is no longer on ‘autopilot’ when it comes to balance sheet reduction. The statement also suggests that there will now be a lengthy pause before the Fed raises rates again. In fact, several analysts expect the Fed to cut rates before it hikes them again. If so, this is a sharp reversal by the Fed and investors should be mindful of what this implies about the health of the global economy. It seems clear that central bankers around the world are deeply concerned about the slowdown we’re seeing in China and the European Union. Just this morning, data showed that China’s manufacturing sector contracted for the second successive month, while Italian GDP indicates that this major European economy is now in a technical recession.

EURUSD breaks above 1.1500

As we can see, this confirmation of Fed dovishness sent the US dollar sharply lower. The EURUSD briefly broke above 1.1500 (the 50% retracement of the September-November sell-off) before pulling back. The question now is if the negative dollar news is out of the way for now, meaning that the focus will return to the Euro zone’s issues, of which there are many. Not only do we see weakness across the three largest European economies (Germany, France and Italy) but there is growing political uncertainty as well. Add in Brexit and the situation looks pretty grim, certainly not one which will persuade the European Central Bank to raise rates anytime soon.




 
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