The following article is courtesy of AETOS analyst Ryan Chen. Part I and Part II of the report can be seen here and here.
Impact on foreign currency market of the Fed’s policy shift
Ryan Chen
It is a fact that the Fed has entered the end of its tightening cycle. However, in currency markets, even after the March meeting in which dovishness prevailed, the demand for the dollar dropped sharply on the second day.
The main reasons for this phenomenon are the expected repair and peer foils:
Expected repairs: The Fed’s plan to keep the size of its balance sheet “above pre-crisis levels” was not a decision made in 2019. The document “Policy Normalization Principles and Plans,” published in September 2014, and the supplemented document released in June 2017 stated, “The Fed’s reserve balance will eventually be higher than before the crisis.” Prior to the March meeting, several senior officials of the Fed gave speeches to inform the market to a certain extent. As a result, on the eve of the March meeting, a number of institutions expected the Fed to release details of changes to the size of its contraction, although most of them failed to expect the pause to be the end of the third quarter. In other words, there is no “reversal” in market expectations of the Fed’s monetary policy. Market pricing only needs some adjustments and repairs.
Peer foil: As of March 2019, the size of the Fed’s balance sheet as a percentage of the U.S. GDP has dropped to 19.0% from its peak of 25.3% in December 2014, well below the Eurozone’s 40.4%, and far lower than the Bank of Japan in the pursuit of its easing policy, in which the balance sheet now stands at 102.2% of GDP. Additionally, the Fed started to raise interest rates at the end of 2015. By March 2018 it had raised interest rates nine times, totaling 225 BPS, leaving other central banks far behind.
It is now more than ten years since the financial crisis, and central banks around the world have come to the point where their monetary policy is to be changed, including the BOJ, which has followed an easing policy alone; the ECB, which has drawn up plans for a new round of TLTRO; the Bank of England, which is caught in the Brexit whirlpool; the RBA, which has explicitly opened its options for a rate cut; and the Bank of Canada, which has been described as “practically surrendered.” The Fed has certainly gone farther than other major central banks in its post-crisis normalization of monetary policy, a move that was strongly supported by the relatively stronger fundamentals of the U.S. economy. Thus, the dollar continues to be attractive at the end of the Fed’s tightening cycle.
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