Why A Hawkish Fed Is Negative For Dollar This Time?

Fed’s balance sheet unwinding may hurt sentiments on stocks. Good opportunity to buy gold?

Fed’s downgrade on its long-term target rate to flatten yield curve, which is seen as negative to dollar

Fed appeared to be hawkish in its FOMC September meeting. Not only did they offer the timetable for its balance sheet unwinding, but also outlined another 3-4 interest rate hikes by end of next year. But we must take note Fed downgraded its long-term Fed fund rate target by 25bps, such move immediately flattened US Treasury yield curve. A flattening yield curve could be negative to the currency. Despite dollar moving higher after FOMC meeting, we saw that as a knee-jerk reaction, instead of a sustainable move.

Fed held benchmark interest rate unchanged as expected last week.  Fed confirmed they will start to unwind its balance sheet in October, as recent hurricanes may not have a long-term impact on the economy in their view. At the same time, Fed raised the growth forecast to 2.4% from previous 2.2% this year, but lowered the core inflation forecast to 1.5% from 1.7%. What Fed foresees its economy outlook to be is like ECB: a higher growth with a slower inflation outlook.

In general, Fed’s statement looked hawkish. According to textbook rule, investors should buy the currency when its central bank seeks to tighten the monetary policy. However, it could be different this time. As mentioned above, Fed downgraded its long-term Fed fund rate target by 25bps to 2.75%. Why Fed did that? We think the reason behind the curtain is because Fed doesn’t want to see the curve steepen too much. A few years ago, Fed expected the peak rate at 4.25% in current tightening cycle.

Despite Fed “saying” they are going to tighten for at least next 15 months, rates market seemed not buying that story. After FOMC meeting, 2-30 Treasuries yield spread narrowed to 136 bps, the least since June; while 5-30s’ spread narrowed to 93 bps, the least since July. Hence we can almost conclude the rates market was paying more attention to Fed’s outlook on its mid-long term interest rate than the pace of tightening. If market starts to increase the portfolio on long tenors’ US Treasuries, the depressing curve could pressure dollar lower, especially when euro zone and UK’s yields are likely to edge higher as ECB and BOE looked ready to tighten.

We still view Fed’s current tightening cycle is reaching a mature stage, even as it is still looking forward to hiking rates in 2018. Historical data showed each Fed’s tightening cycle was around two years, with only one exception in 1976, which lasted for four years. In other words, current tightening cycle started from 2015 could be reaching a mature stage.

No matter how skillful Fed’s communication is, the path of unwinding the balance sheet cannot avoid an increasing volatility in capital market, due to its unknown impact to the economy. In other words, VIX is set to rise from the current historical level. Investors could seek safe-haven assets such as gold, US Treasuries and Japanese yen.

Our Picks

NZD/USD – Slightly bearish.

This pair may drop further towards 0.7225 amid political uncertainties after the election. 

 

USD/JPY – Slightly bearish.

Fed’s unwinding may spur some flows into safe-haven assets. This pair may dip towards 111.70. 

 

XAG/USD (Silver) – Slightly bullish.

We expect price to rise towards 17.25 this week. 

 

XAU/USD (Gold) – Slightly bullish.

We expect price to rise towards 1300 this week.

 

Top News This Week (GMT+8 time zone)

New Zealand: RBNZ rate decision. Thursday 28th September, 4am.

We expect figures to remain unchanged at 1.75%.

Euro Zone: CPI y/y. Friday 29th September, 5pm.

We expect figures to come in at 1.3% (previous figure was 1.2%).