Head of FX Strategy
Summary: Yesterday, the Fed was forced to offer a rare overnight repo to ease funding pressures in the US banking system. The Fed can no longer ignore the USD funding issue in its communications on policy from here and the discussion around this issue ccould dominate the USD narrative from here.
Trading Interest
To ease a sudden spike in funding pressures, the Fed was forced to do an overnight repo yesterday for the first time in more than a decade. Contributing to the spike in funding pressures was apparently a crush of corporate quarter-end tax payments, but some have pointed to large Saudi cash raising efforts in the wake of the refinery attacks as an emergency factor as well. Regardless, the situation has only arisen in the first place because the reserves in the US banking system are running low, a long term process we have discussed before that is driven by widening Trump budget deficits, foreign central banks no longer funding those or the general US current account deficit and increasingly insufficient domestic savers in the US able to fill the gap.
I have seen all manner of expert discussion on how the Fed can address the funding pressures with various mechanisms and cap raises on this and that, but the bottom line is the same: the reserves are running low and the Fed is losing control – will it simply surrender and open the floodgates at every turn when these funding pressures arise – effectively restarting involuntary QE, or make life difficult for those in need of funding? If yesterday is any indication, the Fed will default to keeping control of rates, not the balance sheet. If so, this may be the beginning of the end of the strong US dollar. But if the Fed shows signs that it is reluctant to lose control of its balance sheet and wants to put up a fight, we could yet have one last spike higher in the USD.
Beware the initial reaction to tonight’s FOMC, as the algos comb over the implications of wording shifts in the new policy statement on the economy and micro-adjustments to the “dot plot” forecasts of the Fed policy rate and projections in the accompanying materials to today’s statement. We shouldn’t be surprised, for example, if the Fed shows some caution by adjusting employment and growth projections in a slightly more pessimistic direction. But it is the funding issue and any communication related to that in the statement or in any special publications or new initiatives/facilities aimed at addressing the issue, as wel as Powell’s answers on the issue in the press conference Q&A that could carry the day and drive the bulk of the market’s assessment in coming sessions.
One thing driving considerable cognitive dissonance for this analyst are the simultaneous signs of a USD funding crisis with mind-bending complacency in credit spreads, including for EM – the assumption is apparently that the Fed will always and everywhere respond with the requisite easing. Brazil will today prove the latest EM central bank to feel comfortable in cutting rates as EM momentum is at full thrust – market looking for a 50 basis point chop to take the rate to a new record low of 5.50%.
Chart: USDMXN
USD versus EM crosses should be extremely reactive over tonight’s FOMC meeting if the market hears something that is deemed unfriendly to some of the most complacent conditions in risk sentiment we have seen in recent years – whether that is from a tone deaf discussion of economic models and no discussion of the balance sheet or other cause for alarm. A pair like USDMXN has recently worked down to pivotal levels on these very EM-friendly conditions , with the Fed needing to signal further support for risk-taking in today’s FOMC to encourage a full reversal of the August rally by cutting down through 19.25.
The G-10 rundown
USD – the USD in limbo ahead of a pivotal Fed meeting, which is about Fed balance sheet issues and the link to USD funding and how honestly these are discussed and the guidance related thereto, more than any discussion of the economy and rates.
EUR – Euro bounced yesterday, perhaps on the implications of the Fed’s QE and the sense that the Fed will be forced to ease from here, while the EU can fund its own fiscal, given its large external surpluses.
JPY – would have thought easing oil prices and comeback in treasuries would do more to support JPY – general max complacency in risk appetite may be a driver of JPY still on defensive
GBP – market is oddly enthused about the pound, we are cautious, as any positive story will be flow related on hoped-for Brexit catalysts, as the credit impulse tells a scary story of hard recession incoming.
CHF – high risk complacency and the ECB lacking any further bite and hope for EU shift to fiscal likely behind EURCHF trading up against 1.1000, with 1.1065 a larger level a bit higher.
AUD – the latest Australian jobs data up tonight as traders have taken a shine to AUD lately on resurgence in risk sentiment and hopes for the US-China trade talks next month. AUDUSD in a pivotal area.
CAD – USDCAD in limbo as we await market’s assessment of the USD post Fed – ugly manufacturing sales data out of Canada yesterday, by the way.
NZD – the Q2 (a bit old…!) GDP release tonight from NZ in focus for relative strength via AUDNZD as we need new catalysts to drive interest in further NZD weakness.
SEK – the krona is on the defensive after terrible unemployment data with the backdrop fairly supportive, so if we shift to an unsupportive backdrop (concern that the Fed will remain behind the curve), risk of EURSEK pulling to new highs for the cycle.
NOK – if Norges Bank is going to hike again, it might as well get it over with at tomorrow’s meeting – but the hikes in the bag have done little for NOK – even with the more supportive backdrop of late. Odds only slightly in favor of a Norges Bank pass tomorrow. Worth noting that short rates in Norway near highs for the cycle.
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