Fed unwinding balance sheet plan may wane sentiment in risk assets, sell USD/JPY?
Fed may announce balance sheet unwinding plan in September while holding the policy rate unchanged
Dollar dropped to a 14-month low last week as investors refined their reactions to a dovish tone from the Fed. FOMC signalled it is ready to start unwinding its crisis-era stimulus program as soon as its next meeting, but its outlook on US inflation weighs on dollar’s sentiment.
Fed kept rates unchanged at 1% to 1.25% at the meeting as expected by financial markets. But in a sign of resolve on its policy committee, Fed said in a statement that it is ready to start paring back the size of its balance sheet “relatively soon” as long as the economy stays on track.
In the statement, Fed said the Committee expects to begin implementing its balance sheet unwinding program relatively soon, provided that the economy evolves broadly as anticipated. This is in line with public guidance from Ms Yellen herself. However, we think balance sheet unwinding may not be a positive event for US dollar.
Yellen acknowledged in testimony to Congress this month that the deceleration in inflation growth may not only be a result of one-off factors such as recent cuts to mobile phone charges. If soft inflation persists into the second half of the year, doves within Fed are likely to hold the current rate for some time, putting doubts in current expectations for rates move by end of the year.
No matter whether Fed is hawkish or dovish in coming month, yen is likely to be favoured, and here are the two different scenarios illustrated,
Scenario 1: Fed holds both policy rate and size of balance sheet unchanged due to weaker inflation outlook.
Weaker dollar prospects are likely to intensify as market expects the current Fed tightening cycle established from December 2015 is going to mature soon. This is negative for the dollar especially when the rest of the central banks are catching up its tightening pace such as ECB, BOC etc.
Scenario 2: Fed to announce balance sheet unwinding plan as inflation growth remains on track.
With little doubt in market, rallies in global equities in recent years are buoyed by the central banks’ stimulus. Fed is one of the champions of doing that. Once Fed starts to reverse its balance sheet strategy, there is a high probability for US stocks to trade lower. A less risk-on sentiment in global capital market set for increased demands on the safer assets such as Japanese yen, gold and German, US government bonds etc.
Our Picks
EUR/USD – neutral. We expect this pair to continue rising in coming weeks amid less accommodative ECB. However, it may experience some price pull-back before it edges higher. Price may retreat to 1.1640 this week.
USD/JPY – Slightly bearish. Pair may fall towards 110.
XAU/USD (Gold) – Slightly bearish. We expect dollar to have some technical rebounds this week, such price action may drive gold price lower towards 1260.
Top News This Week (GMT+8 time zone)
Australia: Rate decision. Tuesday 1st August, 12.30pm.
We expect the rate to remain unchanged at 1.5% (previous figure was 1.5%).
U.S. : Nonfarm payrolls. Friday 4th August, 8.30pm.
We expect figures to come in at 190k (previous figure was 222k).
Fullerton Markets Research Team
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