Central bank showed respect to financial markets, responding to their signals

If anybody doubted in the Fed willingness to take a long break in normalizing its monetary policy, then after the minutes of the December FOMC meeting and the central bank representatives’ comments were published, any doubts disappeared. The Fed increased the rate to 2.5% and noted that, according to the current economic data, it is reasonable to raise the indicator a little; however, the turmoil in financial markets and the concerns about global economy future, make the scale and the terms of the federal funds rate changes unclear. Considering the slight inflation pressure, the Fed can afford to be patient in the tightening its monetary policy.

The minutes showed that the policy-makers are willing to completely give up the words about further gradual raising the interest rate. The Federal Reserve did so in 2006, when it ended the cycle of its monetary restrictions. The stock indices responded to the publication by a rise; the Treasury yields and the dollar dropped. Why was there a different trend in December? The equities, after the 13% drop since late September, were down by 1.5% more. Investors could be charged with inattention, Jerome Powell – with a wrong wording of his speech. In particular, The Fed CEO was too early to announce that the low inflation rate allows the central bank to be patient. In January, he replaced patience with flexibility, pushing the stock indexes up. You need to repeat the sames thing to the market a few times, to help them determine their trends at last.

After all, the Fed’s attention to the signals, sent by the securities, is commendable. This also includes the regulator’s willingness to correct the process of reducing its balance sheet. It has been reduced down to $1.51 trillion, compared to its highest value of $2.7 trillion in 2014. In addition to the federal funds rate hikes, it was resulting in the yield growth of the short-term Treasury bonds, thus flattening the Treasury yield curve. The indicator inversion has predicted the last five out of five recessions.

US Treasury yield curve


Source: Wall Street Journal.

The matter is if it signals the recession or triggers it. The panic, associated with the indicator slide down to the red zone, triggers sales in the US equity market, whose price drop encourages foreigners to wind down business investments, and finally presses down the GDP growth rate. In this situation, the Fed willingness to pause normalizing it monetary policy seems to be the right decision. It should reassure the financial markets.

A long period of the central bank’s inaction is a strong argument for glandual exiting USD long trades. The EUR/USD pair has at last stormed the resistance at 1.148-1.1485 and is free to go up. It is also due to the dovish comments by the former Fed hawks, Charles Evans and Eric Rosengren, as well as the euro-area unemployment rate drop down to 8%, the lowest level since 2008. In addition to this factor, the higher growth of European earnings encourages the ECB to raise the interest rate in September and supports the euro.

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Price chart of EURUSD in real time mode

Fed’s hat is off

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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