The FOMC voted 11-1 today to maintain its 85 billion dollars in monthly asset purchases. The central bank justified its decision by highlighting its concern that rising market rates for debt ranging from corporate bonds to mortgages may threaten the still fragile recovery. The committee also stated that further fiscal tightening by the Federal government continues to be a major downside risk for the economy. Finally, the lack of robust data to indicate a broad recovery in labor markets also gave the Fed pause. Particularly, the committee remains concerned about the recovery's "staying power," as highlighted by Chairman Bernanke's use of this term during the post-release press conference.
On FX, the dollar was broadly weaker. Falling substantially against all major currencies. The dollar also sank against EM currencies. The Mexican Peso soared nearly 3000 pips against the greenback, or 2.3 percent. As of 11:26 GMT, one USD fetched 12.66 MXN, compared to 12.97 when morning trading started in New York. This represented the biggest one day move in nearly two years. TRY also had an incredible day, moving an amazing five big figures. The lira, which has been under tremendous pressure due to taper fears moved to 1.95 against the USD, as compared to 2.00 yesterday.
In general several key points can be taken Fed's statement and the market reaction. First, the Fed still believes that quantitative easing can help fuel a stronger recovery. Many voices, from outside the Fed and few on the inside such as Dallas Fed President Richard Fisher, had made clear their belief that QE had already done all it could to help jumpstart the economy and that further easing would have little to no effect. The Fed's willingness to continue its asset purchases at the same 85 billion per month clip means that the FOMC rejects the pessimistic "monetary policy has done all it can" view of some economists. Crucially, we note that the Fed remains committed to weighing the downside risks of its easy money policies. It therefore appears unlikely that the central bank would continue with its asset purchases if it did not believe they would have a tangible effect.
Secondly, board's outlook on inflation remains subdued, and the Fed in general remains confident that it can exit without causing markets to panic or the real economy to suffer.
The Fed remains acutely aware that bond traders are terrified by the potential dumping of trillions of dollars worth of securities onto the capital markets if the Fed unwinds too quickly. The Fed therefore is likely to use other tools to tighten monetary policy, rather than selling securities. When I spoke with one senior official at a regional Fed who was involved with preparing briefings for this month's meeting, they stressed the Fed's new authority to pay interest of reserves. They also mentioned that while the central bank is confident that the capital markets are deep enough to absorb very large asset sales by the Fed, the central bank has no desire to be "a bull in a china shop." Therefore, asset sales, if they occur will be slow and measured. In general, my numerous discussions with Fed officials over the past year have centered around alternatives tools the Fed has at its disposable. A mass dumping of Treasuries and MBS on the markets therefore seems unlikely unless inflation reached double digit levels.
Finally, we note that communication and forward guidance remain the most important factors in the outlook for rates and FX markets. The Fed has already tightened policy in that last three months by signalling the possibility of a reduction in asset purchases this fall. It is particularly troubling that the "tightening financial conditions" cited by the FOMC as threat to the recovery were essential created by the committee's own actions. It is unclear whether or not the Fed intended for market rates to rise, but if it indeed believes that rising mortgage rates and bond yields have dampened the recovery, we've just gone through three months of volatility for nothing.
In general, today's news is probably a green light to sell the greenback against EM currencies with strong fundamentals. Then again, the waiting game continues now for when the Fed will actually taper, so expect volatility to remain very high.
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