5 Reasons, 6 Scenarios, & 7 Potential Currency Reactions

With all eyes and ears glued to the FOMC meeting currently underway, Yohay Elam of ForexCrunch, details some potential scenarios and results that could unfold based on their announcement.

The Federal Reserve convenes for a highly anticipated meeting to make a decision about QE tapering. There is a very high probability that the Fed will announce a reduction in the pace of bond buying today, and probably by $10-15 billion to $70-75 billion.

Here are five reasons for the expected tapering, six scenarios for the decision and the all-important accompanying statement, and the potential reactions of seven different currencies, some are weaker and some are stronger.

The statement and economic projections will be released at 18:00 GMT, and Bernanke will face the press at 18:30 GMT.

5 reasons why the Fed will taper:

Ongoing Recovery: Despite the recent weak employment report, the US is still growing and creating jobs. Jobless claims are edging lower and PMIs show an intent to hire. This recovery isn’t that strong, but at this point, the effectiveness of bond buying is limited in creating a “wealth effect” that Bernanke mentioned.

Fear of Inflating Bubbles: Bernanke and co. can look at QE and see it as a success story in the housing market, with a clear recovery. However, with house prices rising around 12% YoY (Case Shiller), perhaps the time has come to reduce the level of stimulus (the Fed doesn’t see tapering as tightening) to avoid blowing a bubble. In addition, the Fed might worry about other bubbles in stocks, commodities, and emerging markets.

Thick Hints: The notion that the “Septaper” is coming is strengthened by recent comments from Fed officials, that come with “an open mind” to tapering in September. This includes the doves. With the Syrian issue somewhat defused, there are very little chances that the Fed will not taper.

Legacy: We now know that Summers will NOT inherit Bernanke. Even if Bernanke stays on the job and doesn’t evacuate his chair for Janet Yellen, he would probably like to begin unwinding the biggest monetary stimulus in history and not leave it as a hot potato.

Passing the Ball to the Government: the Fed would prefer that the government pick the baton and provide address the sequester. They already criticized the government for lack of short-term stimulus and talked about things that are out of their realm.

All this leads to the conclusion that tapering will be announced today.

6 Scenarios and USD Reactions

This is a big shift in policy as it is the beginning of the end of QE: the beginning of the end of printing dollars: a positive for the dollar and negative for bonds, commodities, and stocks.

QE tapering is not fully priced in, and we could see the dollar strengthening afterwards. A lot depends on the guidance to the next tapering steps, and this remains a mystery for now.

Here are the scenarios, starting from the more probably ones to the less probable ones:

$10 billion tapering and intent to end QE in mid 2014: This scenario has the highest chances: a relatively symbolic reduction of QE would send a message of a shift in policy, but is a cautious move that leave the door open to a slow and gradual process. Sticking with an intent (not a commitment) to end QE by mid-2014 would be a repetition of what Bernanke said in June. This scenario is almost priced in: the dollar would strengthen, but in a limited manner.

$15 billion tapering and intent to end QE in mid 2014: This scenario also has good chance but would be more dollar positive as it reaches the higher end of expectations.

NEXT PAGE: Potential Currency Reactions

$10 billion tapering and no future hints: In this scenario, tapering would be seen as a very cautious and perhaps only symbolic move, but without any quick follow through to end QE: an initial move that will be very carefully assessed afterwards. Such a decision would significantly weaken the dollar and strengthen stocks, as it could be perceived that the easy money will continue flowing. Chances are lower.

$15 billion tapering and no future hints: This has somewhat lower chances, and will leave markets somewhat confused, but tapering at the higher range could slightly help the dollar.

$20-25 billion tapering: A more significant tapering cannot be ruled out, as the total monthly buys stands at $85 billion, and the timetable until mid 2014 is not that long. In this hawkish scenario, the dollar would soar as it is beyond the consensus. The scenario has little chances.

No tapering: Given recent worries from retail sales and jobs, also this scenario cannot be ruled out. Tapering could wait for one of the two remaining meetings until year end. A cautious approach by the Fed would send the dollar sinking as markets are expecting tapering. Given all the hints, this scenario has low probability.

Potential Currency Reactions

There are differences between the various major and minor currencies, and reactions could vary significantly. Here is a ranked list of currencies, from the strongest to the weakest. A stronger currency would potentially lose less or gain more against the dollar than its peers, while a weak one would lose more or gain less if the dollar falls.

GBP: Recent data from the UK has been outstanding (Q2 growth, Q3 PMIs, employment, etc.) and the pound took its time with reacting. It still remains its strength.

NZD: New Zealand’s food exports have survived the milk scare, and money continues flowing into its real estate. With intentions to raise rates in 2014, also the kiwi still has room to rise.

CAD: The loonie was temporarily on the back foot, but the recent employment report certainly helped it. Tapering that comes on the background of US strength is positive for Canada, that relies on US demand. Tapering that is only meant to prevent bubbles is not that positive.

CHF: The franc is still looking for a direction and is still pegged to the euro. With the quarterly rate decision just half a day after the Fed’s decision, the franc remains in the middle of the list.

JPY: While a big tapering could trigger safe haven, yen positive flows, higher US yields support a stronger USD/JPY. In addition, talk about monetary and fiscal stimulus weigh on the yen.

EUR: With German elections just four days away, Draghi’s warning on the freshness of the recovery, worrying economic signs from Germany and the looming third Greek bailout, the euro remains vulnerable.

AUD: The excitement from the new Australian government and Chinese stability seems over, as unemployment rises in the land down under and the transition away from mining could take a long time. The Aussie is a classic risk currency that still needs US flows.

That’s it. What do you think? Will the Fed taper? How much is already priced in? Where will currencies be at the end of the week?

It’s important to remember that the initial reaction to FOMC statements is not necessarily the long-lasting one. The full effect can sometimes be assessed only in the US session in the following day.

By Yohay Elam, Founder, Writer, and Editor, ForexCrunch.com