The U.S. Federal Reserve building in Washington, D.C
We believe investors in the forex market and financial community in general overreacted to the FOMC minutes. The price action in equities, treasuries and currencies suggests that there was major shift or revelation by the Fed but in reality the minutes contained very little surprises and did not say anything that we had not all already known. The Federal Reserve is likely to taper in the coming months based on better data and considering that the December, January and March meetings are all in the "coming months," the Fed's guidance is consistent with market expectations. Monetary policy committee members also discussed various scenarios under which it may be appropriate to begin tapering sooner and this is also not surprising because it is their job to discuss all options. The Federal Reserve saw very little changes in the economy from the September meeting. The recovery is continuing at a moderate pace with further improvement in the labor market. However the recovery in housing is slowing, fiscal policy is still restraining growth and consumer sentiment remains unusually low. While the downside risks to the economy have diminished, there are still "several significant risks."
In other words, even though the U.S. dollar soared, equities erased earlier gains to end the day lower and 10 year Treasury yields rose to a 2-month high, not much has changed. Before the minutes were released, there was an 80% chance that tapering would occur in January or March and those odds remain the same especially after today's sharp rise in yields. If 10-year Treasury yields are at 3% or higher come December U.S. policymakers will be reluctant to reduce stimulus prematurely and risk an even larger rise in yields. In fact, Fed Chairman Ben Bernanke told us with very little ambiguity last night that the decision to taper next month hinges largely on where U.S. rates are at the time. If 10-year yields are above 2.85%, the Fed will stand down. If rates are 2.7% or lower, pre Christmas tapering remains on the table. U.S. retail sales rose 0.4% in the month of October, the strongest pace of growth in 3 months and excluding auto and gas purchases retail sales rose a more than expected 0.3%. Not only were there broad based gains in spending but the September figures were also revised up from -0.1% to 0.0%. Despite the U.S. government shutdown, October has turned out to be a good month for the U.S. economy and this leads us to wonder how much stronger the recovery would have been if the U.S. government remained opened throughout this time. Between the sharp rise in non-farm payrolls, the increase in retail sales and the expectations for a snapback in November, GDP growth is expected to accelerate in the fourth quarter.
However even though we think the market overreacted to the FOMC minutes, we don't feel that the rally in the dollar is unjustified. We have long said that the trajectory of U.S. rates is higher and as long as this remains the case, the dollar will rise and its strength will be most pronounced against currencies whose central banks are still considering additional stimulus. Therefore we continue to look for the EUR/USD to drop down to 1.32 and for USD/JPY to reach 102. It may take some time for this to occur because the Fed could keep monetary policy unchanged next month, disappointing the markets but by the first quarter, the process of unwinding stimulus will have begun and by then, the dollar should be trading much higher.
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