FX Update: USD funding issues in focus over FOMC meeting

Trading Interest

• Flat and with an open mind heading into FOMC meeting

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.