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The greenback was remarkably resilient over the past week, despite the larger-than-expected trade deficit and the larger-than-expected fourth-quarter current account deficit, the main cause of the dollar's decline for so many bears out there. I too had thought the risk on the greenback was on the downside.
Important support for the euro is seen in the $1.3230-50 area. This area was tested ahead of the weekend and it held. However, a convincing break of this could signal another cent decline. On the upside, a move above $1.3360 would help rebuild a more positive technical tone for the euro. Against the yen, the dollar remains confined to narrow trading ranges and my warnings last week of a breakout proved for naught.
Frankly, foreign exchange looks boring compared to the fireworks in the fixed income market. And barring a surprise from the
, this is unlikely to change.
And Now For Something Completely Different
In what is as done of a deal as has ever been done, the Federal Reserve will raise the fed funds rate by another 25 basis points Tuesday, just as it has done each time it has met since June of last year.
The Fed could hardly be more transparent of its intentions to raise the target to 2.75%. Banks and investors use to pay good money to "Fed-watchers" who would pore over tons of data and official comments to divine what the Federal Reserve would do. With the advent of the Fed funds futures market, these latter-day oracles have largely gone the way of buggy-whip makers. Not to mention that the market also provides policymakers with a feedback loop they can use to monitor expectations.
Judging from the recent official commentary, Fed officials seem comfortable with market expectations. The fed funds futures contracts imply that the fed funds target will be lifted by 25 basis points not only at the March 22 meeting, but also at the May 3 meeting and again at the June 30 meeting, so that the rate will stand at 3.25% at midyear.
The pricing of the fed funds futures strip also implies a recognition of the risk that the Federal Reserve may raise rates by 50 basis points later this spring. Currently, the market's collective wisdom is that there is about a 1-in-4 chance of this larger move. In past cycles, it has not been unusual for the Greenspan Fed to signal a pause by delivering a larger rate hike.
Parsing Prose in Place of Action
Perhaps partly because the pundits cannot add much value by predicting what the Federal Reserve will do, they have focused on what the Fed will say. Much of the attention here is focused on whether the Fed will continue to signal that it will reduce the accommodation at a "measured pace." It is well known that Fed officials have debated the continued use of this phrase: Does it reduce their options? Should there be some strategic ambivalence?
The market appears to lean toward expecting this phrase to be dropped this time, and the reasons seem clear. Slack in the economy is diminishing, the Beige Book noted that some businesses are being able to pass through price increases. The strength of commodity prices in general and oil in specific, coupled with the falling dollar, underscores the risk of what some economists call pipeline inflation.
While it is possible that the measured-pace phrase will be altered, it probably is not as significant as all of the ink that has been spilled on what it would suggest. Instead, it seems the focus should be on the Fed's assessment of the risks of inflation.
In the communiques that followed the recent FOMC meetings, the Fed has indicated that its outlook for growth and inflation are roughly balanced. It is in this assessment of risks that the real signal will likely be sent. If the Fed drops the measured pace clause but doesn't change the risk assessment, there might not be much of a market reaction.
But if the Fed changes the risk assessment and acknowledges that the risks of inflation are growing, then the market is likely to see a renewed backing up in yields and an increased anticipation of a 50-basis-point hike later this spring. Indeed, if a 50-basis-points hike is delivered, it would likely be seen as signaling a pause within the current cycle: that based on the data at the time, the Fed thought it had sufficiently approached a neutral rate.
On balance, though, this seems unlikely. Most Fed officials have still maintained that inflation expectations are well contained and seem comfortable with the core PCE measure of inflation in the 1.5% to 2% range this year.
It is true that high oil prices have gone from being perceived by many, including myself, as a transitory phenomenon, to something that will likely be sustained for some time. And although there may be some near-term inflationary implications, keep in mind the difference between relative price increases and general price increases.
For example, gasoline prices are rising, but the more money it takes to fill the auto up at the pump, the less money the household sector will have to spend on eating out, among other things. Inflation is really an increase in the general price level. The higher energy prices represent a relative price increase.
Since the Fed last met in early February, the U.S. 10-year yield has risen around 50 basis points. Spreads between corporate (both investment grade and high yield) and Treasuries have widened, so the market has already done a good deal of heavy lifting for the Fed.
In sum, we are experiencing an adjustment, arguably in a more reasonable direction of risk, which seems to be what Greenspan's conundrum remark was aimed at achieving. The Federal Reserve needs to be concerned that changing its tact now would potentially trigger a more rapid adjustment, which in turn could have systemic consequences. Look, then, for a continuation of the gradualist policies that have served the Fed so well in the current cycle.
Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years. He has worked at economic consulting firms and at global investment banks. Most recently, Marc was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. In September 2004, Chandler started a financial consulting firm, Terra K. While he cannot provide investment advice or recommendations, he invites you to send comments on his column to