How The Market's View Of The Fed Did A Complete 360 In Less Than 24 Hours

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It’s been a whirlwind day in monetary policy, and at the end of it all, nothing has really happened or changed.Yesterday the Fed minutes from the last meeting came out sounding more dovish than expected.

Several voting Fed members appeared to have been this close to pulling the trigger on more QE.

The dollar weakened. Gold shot up. Stocks erased much of their losses on the day.

The reason why the minutes took the market by surprise was that since the last Fed meeting the data seems to have improved, and everyone pegged the odds of more QE being very low.

But then on CNBC this morning, non-voting Fed member James Bullard said the obvious. The minutes are stale.

Here’s Citi’s Andrew Cox:

James Bullard, St Louis Fed President, raised a couple of interesting points during his CNBC appearance earlier today that may weigh heavily on sentiment.  Bullard is not a voter until next year and we do not think that his views are necessarily representative of the Fed’s centre.  However, the points that he raised this morning regarding the stale nature of the minutes and the timing of the Fed’s next step may lead the market to back off some of the significant increase in QE expectations that was priced in yesterday.   Bullard’s first key point was focused on the staleness of the minutes.  Since the Fed’s last meeting on August 1, the trajectory of US economic data has picked up significantly and the perception of systemic risk emanating from the Eurozone has eased substantially.  Asset markets and financial conditions are much improved. 

The sharp reaction to the release of the minutes yesterday suggests that many overlooked the fact that the meeting was held three weeks ago and followed a several month long string of disappointing US economic data.   Bullard’s second key point was focused on the timing of the Fed’s next move.  He emphasised that the he is focused on assessing economic growth in the second half of the year. 

This echoes the comments in the minutes regarding “substantial and sustainable strengthening in the pace of the economic recovery.”  This suggests to us that the Fed is looking beyond just the next round of monthly data points.  Yet, the tone of conversations with clients and colleagues yesterday suggested that many interpreted the minutes as setting up an aggressive Fed response at the next meeting on September 13.  Bullard’s comments this morning suggest that investors and the Fed may have drastically different ideas regarding the meaning of “fairly soon”.  

Where does this leave us for FX?  We would not be surprised to see a partial retracement of yesterday’s sharp moves across USD pairs.  The minutes confirmed the decided easing bias communicated in the August 1 statement and confirmed that the Fed is focused on balance sheet expansion as the primary accommodation tool.  However, the minutes confirmed very little about the timing of the Fed’s next move.  If Chairman Bernanke fails to provide further clarity on the Fed’s horizon and the Fed does not pursue QE on September 13, much of the USD weakness priced in yesterday will likely be unwound.

So now it’s risk-off again, and the market sees things exactly how they did yesterday at this time.

The recent firming in data likely makes QE3 off the table, at least at the next meeting. Long-term, the economy is still humming along at below-trend rates, and anything is possible.

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