Tomorrow brings a rate decision from the Federal Reserve. While there is little expectation for any changes to rates, the prevailing thought is that we’ll hear the bank announce the start of balance sheet reduction, or Quantitative Tightening. This shouldn’t be a surprise, as the Fed has been laying the groundwork for this for much of the year. At the March FOMC meeting, the Fed said that “a change in the Committee’s reinvestment policy would likely be appropriate later this year,†indicating that they would give markets notice well in advance before triggering any such strategy. At subsequent meetings, this topic remained popular, with the Fed continuing to fuel expectations for balance sheet reduction to begin before the end of the year.
Since the topic of balance sheet reduction has entered the discussion, the U.S. Dollar has been pummeled by sellers. And this could make sense if we think of the matter from a perspective of rate expectations. If balance sheet reduction is successful, it should help to lift market interest rates. This could also obviate the need for rate hikes out of the Fed, particularly if inflation in the US remains below the Fed’s 2% target. Given that higher rates are generally the most effective driver of currency prices, the down-trend that we’ve seen in the Dollar this year is likely driven by markets’ expectation for fewer hikes out of the Fed as they begin to tighten the money supply via balance sheet reduction.
As we walk into tomorrow’s Fed meeting, the U.S. Dollar is sitting on a -12.3% drawdown for 2017, with -10.5% of that coming since the day before that March rate hike. The big question is whether the Fed can do anything to reverse this: They’ve been saying for much of the year that they’re anticipating hiking rates while balance sheet reduction ‘runs quietly in the background,’ but this is something that markets are clearly not buying, at least not right now.
