In recent months, every FOMC statement has been treated like the latest release of a Kanye West album: highly anticipated and in the spotlight. No real surprises here homies – after all, there’s been a ton of speculation as to when the Fed will actually start withdrawing stimulus measures.
The problem though, lies in how Fed members are communicating their ideas. Some Fed members are calling for tapering, while others believe the time isn’t ripe yet. This is sending the mixed signals to the markets. This is why tomorrow’s event is crucial. If the central bank can effectively communicate clearly and precisely what it wants to do, the markets will be able to adjust and justify their expectations.
Before I go into the potential scenarios that may emerge from the FOMC statement, I first want to explain to you the difference between the different phases that the Fed can undertake.
- Tapering – This means buying less than the current 85 billion USD per month worth of bonds that the Fed is currently doing. If this happens, the central bank will be buying less each month, but that the balance sheet will still be expanding.
- Pause – Keep monthly purchases at current levels. This is what the Fed is doing right now.
- Tightening – Not only does this entail completely eliminating bond purchasing, but it means that the Fed will also sell the bonds that it is currently holding. This effectively reduces the central bank’s holdings and exposure.
The way I see it, there are three main potential scenarios following the statement: No change, a hawkish statement, and an actual announcement of QE tapering. I’ll discuss each one below.
Based on a recently run poll, almost 66% of U.S. economists believe that the Fed will start tapering its massive monetary stimulus before the year ends, during the fourth quarter. While this might be the case, it doesn’t necessarily mean that they think the Fed will give out hints on this during the upcoming statement.
If the central bank maintains its current rhetoric and shows concern and wary about the economy, it’s likely that we will see the Greenback slightly sell-off, as it will mean that tapering is still far away. It will run against the initial speculation, and suggests that tapering will probably happen only in 2014.
On the other hand, if the Fed hints that it is prepared to taper, it’ll be a clear sign that the central bank has intent. This will most likely be seen as slightly dollar bullish by the market.
Now, if an actual announcement of tapering happens, it’s reasonable to expect that a dollar-buying frenzy will occur. An example of this can be a promise from the Fed that it will scale down its bond-buying program to something like $75 billion a month. This scenario, which has an extremely low chance of happening, has not been priced by the markets, and points to an end to quantitative easing.
Of course, all of these potential scenarios are not written in stone. Nothing in the foreign exchange market is ever certain, so it would be best to consider all possibilities and react accordingly.