FOMC Preview: 3 Key Questions For The Fed

Includes: UDN, UUP
by: Kathy Lien

Intraday volatility in the FX market increased last week on the back of stronger than expected U.S. labor market numbers and ECB comments. The year is winding down quickly but there could be one more push in volatility before everything settles down. Between this year's final FOMC announcement on Wednesday, the EU Leaders Summit Thursday and Friday and the December 16th general election in Japan, there is no shortage of event risks that could increase the volatility in the forex market. For currency pairs such as EUR/USD, we have already seen larger intraday moves even though it remains stuck in a broad 1.2680-1.3125 range. On the other hand, currency pairs such as AUD/USD and to some degree USD/JPY as well have seen limited intraday volatility over the past week. Of these 3 key events, the FOMC announcement will receive the most attention for 3 reasons - #1 the Fed is expected to change monetary policy and #2 the Fed will be releasing its economic forecasts and #3 Bernanke will hold a press conference.

Yes it is that time of the year again when we have an expanded version of the FOMC announcement and here is the schedule:

12:30pm ET FOMC Statement released

2:00pm ET Updated Fed Forecasts

2:15pm ET Bernanke Press Conference

Lets look at each some of these events can impact currencies.

FOMC Statement - Look for New Program to Replace Operation Twist

- Extending Operation Twist is Not an Option

- Fed to Replace Operation Twist with $45B in Treasury Purchases

- Decision will Show Up First in FOMC Statement

Timing is the main reason why this month's FOMC meeting has received so much attention. Operation Twist comes to an end on December 31st and unless the Fed wants to let a significant amount of stimulus instantly evaporate they will announce fresh measures to keep the party going. With the Fiscal Cliff still in the background and the talks going no where, the Fed will want to keep every ounce of their existing stimulus in place in case Congress cannot agree to a reasonable plan by the end of the year. By making major changes to monetary policy at these special quarterly meetings, Bernanke also has the opportunity to provide further details with the hope of minimizing volatility in the market.

Operation Twist was announced in September 2011 with the initial details outlined in the FOMC statement. While they may like to do so, extending the Twist is not an option because the Fed is running out of short term Treasuries to sell. Instead, it is widely believed that the Fed will replace OT with an open-ended commitment to buy $45B in Treasuries every month, bringing their total monthly purchases to $85B ($40B is currently spent per month on Mortgage Backed Securities). This decision will show up first in the FOMC statement as it did in September 2011, giving investors the opportunity to react immediately. Since most investors and economists expect the Fed to convert Operation Twist into additional Treasury purchases, there are 3 main questions that we will be looking for answers to in the FOMC statement:

3 Key Questions on the New Program:

1) Amount of Treasury Purchases - $45B is expected but will it be more or less?

2) What will be the Mix of Assets Purchases - $45B in Treasuries and $40B in MBS is expected

3) Will the Program have an Expiration Date like Operation Twist or be Open Ended?

If all $45B is spent in Treasuries, the impact on the dollar may be more muted. A decision to spend more on MBS and less on Treasuries would be a bit of surprise and could drive the dollar higher as bond yields increase. Some members of the Fed have felt that MBS purchases are more effective than Treasury purchases. An open-ended program will be more negative for the dollar than a program with an expiration date like Operation Twist. However at the end of the day, even if the Fed announces an open ended commitment to buy $45B a month in Treasuries, without sales in the front end of the curve, the overall program should be more stimulative for the financial markets and risk currencies while being more negative for the dollar.

Bernanke Press Conference - Watch for any Skepticism

Fed Chairman Ben Bernanke's press conference is where things can get more interesting as he will be peppered with questions on the economy, monetary policy and potential impact of the Fiscal Cliff. We'll be particularly interested in seeing if he drops clues on the chance of the Fed targeting the unemployment rate. Central bankers have admitted that their forecast of interest rates is ineffective and the lack of price pressures has degraded the significance of an inflation target. Adopting an unemployment rate target would be far more powerful and transparent but it won't come easy given the division within the central bank. In the past, Bernanke's tone has also deviated from the Fed's forecasts so if he expresses skepticism about the recent improvement in the unemployment rate, risk appetite could suffer.

While a change in monetary policy and additional asset purchases are widely expected, there's enough wild cards in Wednesday's announcements to drive up volatility in the forex market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.