The long awaited â€œtaperâ€ has finally arrived, with equity markets taking the announcement in stride and treating the relatively more hawkish statement from the FOMC as an early Christmas present. Â The feeling that the American economy was on strong enough ground the Fed could reduce their monthly asset purchases by $10bn sent stocks to record highs, with the S&P rallying from earlier lows to close up by 1.7% on the day. Â In addition to the beginning of the â€œgreat unwindâ€, the Fed also made sure to reinforce that tapering is not tightening (despite 10yr treasury yields in the secondary market leaking higher post-announcement), and enhanced their forward guidance by suggesting that the exceptionally low level of interest rates would remain in place â€œwell past the time that the unemployment rate declines below 6.5%.â€
The amendment to the previous communication around forward guidance and the 6.5% unemployment threshold gave markets slightly more confidence that the first interest rate increase from the Fed is still a long ways off, especially if inflation remains subdued and below the FOMCâ€™s long-run objective; 12 of the 17 Fed officials now expect rates to be at or below 1% at the end of 2015. Â While yesterdayâ€™s decision to lop off $10bln of monthly asset purchases was slightly ahead of when we forecast the initial taper to come, the choice to pair the reduction in balance sheet growth with enhanced forward guidance was in-line with our expectations, and not necessarily outside the realm of prospects for what the Fed was capable of administering.
Bernankeâ€™s press conference shed a little more light surrounding the future path of monetary policy, and while he reiterated that the pace of asset purchases were not on a preset course, should the incoming data continue to show improvement like it has over the previous few months, the pace of reduction (along with the breakdown of $5bn from treasuries and $5bn from MBS) is likely to continue at subsequent meetings in 2014. Â In short, the Fed will continue to remain data dependent, with incremental gains in productivity and the labour market leading to the gradual unwind of additional monetary stimulus. Â Bernanke also made sure to reinforce the point that Yellen was instrumental in the shaping of FOMC policy during the course of the meeting, signaling to markets there would be continuity from the Fed when Yellen takes over for Bernanke in January.
The reaction across asset markets was initially one of confusion, as stocks, treasuries, commodities, and currencies all whipsawed back and forth as traders and investors digested the news. Â After the dust settled, the outcome was very much USD positive, with high-beta commodity currencies like the AUD and CAD feeling the brunt of the sting. Â The Loonie was squeezed lower as the USD bid-tone sent USDCAD north of 1.07, while AUDUSD dropped into the low-0.88s, and USDJPY tested the waters above 104. Â The small reduction of liquidity from the Fed sent the DXY ramping into the mid-80s, while treasury markets were less impressed, and after the initial knee-jerk reaction the US 10yr grinded higher to end at 2.897%. Â The outcome of yesterdayâ€™s meeting reinforces our thesis that the USD is poised to enter 2014 on solid ground, with the eventual unwind of additional stimulus underpinning the big dollar as interest rates in the secondary market gradually increase.
Equities traded in positive territory during the overnight session, clinging to the back of gains seen on Wall Street with the Nikkei positing an increase of 1.74%. Â While the Bank of Japan isnâ€™t expected to make any major policy amendments at their meeting tonight, the negative trade balance data from earlier in the week will likely continue to put upward pressure on USDJPY as traders assess the growing divergence between monetary policy regimes in the US and Japan.
European bourses are seeing a similar shade of green on tradersâ€™ screens, with the majors playing catch-up to the Fedâ€™s non-aggressive taper decision as the Dax, FTSE, and Stoxx are up by 1.37%, 1.14%, and 1.49% respectively. Â After the initial spike that saw Cable trade into the high-1.64s, GBPUSD has retraced those earlier gains, backing away from the 1.64 handle as retails sales in the UK increased by less than expected for the month of November. Â The y/o/y reading missed forecasts coming in with only a 2.0% increase, however this was up from the 1.8% that had been registered in October, as clothing sales were spurred by a colder than anticipated month.
Heading into the North American open, futures are displaying a slight weight to the tape, seeing a little bit of an easing from yesterdayâ€™s aggressive rally. Â Unemployment Claims, Existing Home Sales, and the Philly Fed Manufacturing Index are all on tap for later in the session, and while they will not have the same market-moving power as the FOMC yesterday, a positive economic docket will continue to put upward pressure on the USD as it reinforces the unwind of QE. Â The Loonie struggles continue this morning, with little interest from market participants to increase exposure to the commodity-linked currency considering FOMC decision. Â Copper futures are down 0.74% Â Gold encroaches on the $1,200/ounce level, and WTI remains flat just south of $98/barrel, so there is little working in the CADâ€™s favour in terms of its traditional drivers.
Turning our attention to the beleaguered Loonie, domestic inflation numbers are due outÂ tomorrowÂ and could give the CAD a slight reprieve, or escalate the sell-off and send USDCAD to new highs depending on the strength of the release. Â Expectations are that we see the core reading remained pinned at an increase of 1.2% when compared to the last twelve months, while the headline reading moves up from 0.7% to 1.0% over the same measurement period. Â With the Bank of Canada taking a keen interest on inflation remaining persistently below target, consumer prices will have more of an influence on price action in the Loonie moving forward. Â A warmer than expected reading would provide some relief to the recent pressure the Loonie has succumb to, while a print that misses the median analyst forecast will likely accelerate the upward momentum in USDCAD. Â With price action stretching the upward Bollinger Bands, further weakness in the Loonie would see the pair test 1.0750 at the top of the trend channel drawn from the September rally, which if broken, would open up room for the pair to make a run at the May 2010 high of 1.0850.
FX Outlook 2014 â€“ Conditional Dollar Strength