After the Bank of Japan (BoJ) and the European Central Bank (ECB) both downgraded their economic assessments last week, it looked like the USD Index would challenge the 3-week high at 96.65 during Friday’s trading session.
However, two headlines hit the newswires midway through the London session which triggered a sharp reversal in the Greenback into the weekend.
The first was a rumour that an US Treasury official has speculated that this week’s mid-level meetings with Chinese trade representatives could lay the ground work for a comprehensive unwinding of trade tensions between the world’s two biggest economies.
We have heard this before and aren’t convinced that China’s promise to increase US agricultural purchases and pledges to reduce their trade surplus with the US is enough to negate the current trade tariffs in place.
The second headline was a Wall Street Journal article quoting an unnamed FOMC official who said the FED would “reduce or halt” the tapering of the central bank’s balance sheet as early as this week’s meeting.
This was the news that really prompted Forex traders to dump the USD. By the NY close, the EUR, AUD, GBP and NZD had all gained over 1% on the day against the USD.
Since the FED Funds futures market is pricing in less than a 10% chance of a rate hike at Thursday’s meeting, comments about the FED’s balance sheet will likely be the primary driver of currency flows on the day and into Friday’s US Non-Farm Payroll data.
With so much potentially on the line for currency markets, we believe it’s worthwhile to review the FED’s tapering so far and what the market could expect after FED chief Jerome Powell takes to the podium for his press conference this week.
During the FED’s Quantitative Easing (QE) program, the balance sheet swelled from $1.8 trillion in 2009, to just over $4.5 Trillion in October of 2017. This is when the FED began retiring maturing bonds at a rate of $10 billion per month.
By October of 2018, the pace of monthly reductions had increased to $50 billion per month, which pencils out to over $400 billion in holdings retired and out of the financial system over the last 15 months.
The composition of the balance sheet is primarily US Treasury paper and Mortgage-backed securities (MBS). According to the Federal Reserve’s schedule of projected runoff, $256.4 billion worth of US Treasuries and $205.7 billion of MBS will roll off the balance sheet in 2019.
This total of $462.1 billion in retired assets represents a reduction of the FED’s balance sheet of about 12%. If, in fact, the FOMC decides to alter this schedule, we believe logical plan would be to continue to retire the MBS and reduce the roll off in the Treasury Securities.
From a transactional and procedural perspective, it would be easier for the Fed to reinvest the Treasury proceeds than the MBS since there is no mortgage market risk in the deep and liquid Treasury market.
It’s our base case that market commentators calling for a sharp reduction, or halt, to the normalization of the balance sheet have underestimated the resolve Mr Powell and his voting FED governors. Still, even if the FOMC cuts the balance sheet reduction plan by half, removing 6% of the FED’s holdings represents a tightening of underlying financial conditions which is unmatched by any other G-7 Central bank.
As such, we would consider any USD weakness into Thursday’s FOMC meeting as transitory and corrective in nature.
With ECB chief Mario Draghi scheduled to address the EU Parliament in Brussels later today, the EUR/USD has traded in a narrow 25 point range between 1.1400 and 1.1425 during the Asian session. We are currently short the pair at 1.1465. We suggest adding to short positions at 1.1485 with an initial target of 1.1170 and a 1.1585 stop.
The Aussie dollar extended Friday’s gains up to .7205 and we see firm resistance in the .7225 area. Friday’s sharp rebound off of the .7075 low triggered our .7180 stop level on our short position from .7155. We suggest selling AUD/USD at .7185, or better, with an initial target of .6930 and a .7285 stop.
The Sterling should have another Brexit enhanced week with the focus turning back to the Irish “backstop”. Our suggestion to sell GBP/USD at 1.3155 was filled. We suggest looking to add to short positions at 1.3235 with an initial target of 1.2840 and a 1.3375 stop.
We are still flat the USD/JPY as our sell suggestion at 110.30 was not filled. We suggest that short-term traders can look to sell the pair at 109.50, or better, with an initial target of 107.30 and a 110.60 stop.
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