Here's Why The FOMC Statement Was Bullish For The U.S. Dollar

 |  Includes: TBF, UUP
by: Thomas L. Bruce

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As you can see from the chart above, the U.S. Dollar Index sold off hard (beginning at 12:27, leak?) going into the FOMC Statement. This market reaction came as a surprise to me since I felt like the Fed largely just met expectations. It had been widely reported that Operation Twist would likely be replaced by $45 billion in monthly long-term Treasury purchases... Even during the press conference Bernanke pointed out that nothing really changed as far as asset purchases are concerned.

So why did the dollar sell off? Well, quite honestly I think that is a tough question to answer because I believe the FOMC Statement was actually very bullish long term. What really stood out to me was that in previous statements it included a sentence which read:

In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

This month, as you're probably already aware, this portion of the statement was drastically altered to read:

In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

For the first time the Fed has given unemployment and inflation targets that will influence the decisions on monetary policy. Different analysts will have different opinions about the implications of this change, but it seems clear to me the primary reason this change was made is because the Fed realizes it is going to have to raise rates earlier than previously anticipated.

The U.S. economy has really begun to pick up over the past year. It is widely believed now that the housing market has started to rebound and the unemployment rate continues to regularly tick lower (as does the participation rate, but that is beside the point). ZeroHedge wrote a interesting article that made a very good observation about the declining unemployment rate:

Indicatively, using a simple forecast, based on LTM trends across all key employment metrics reveals something very troubling, for the Fed and stocks that is: the 6.5% unemployment rate will be breached in July 2013! Now granted that is simply idiotic, and there is no way that the US economy could possibly recover that fast, but that is precisely what is implied based on the ongoing collapse in the Labor Force Participation, and the concurrent plunge in the Labor Force Participation rate, which has been the biggest marginal driver for the unemployment rate, far more than the number of people who have jobs, or are unemployed (readers can recreate our calculation on their own in 10 minutes with excel).

I too don't really believe the unemployment rate will really be below 6.5% next July, but this time next year I think it is a real possibility and the Fed doesn't want to commit to holding rates down until mid-2015 if this is indeed what happens. If I had to guess, pending nothing terrible happens with the Fiscal Cliff or Europe, I'd assume we're looking at higher rates in early to mid-2014. Holding interest rates low a year beyond this would be irresponsible and inflationary, so this month's move safeguards the Fed against a loss in credibility in the likely case it needs to raise rates early.

If you'd like to place a trade based on a early rise in the federal funds rate, taking a long position in UUP (long U.S. dollar) or TBF (short long-term Treasuries) would likely give you favorable exposure. Similarly, interst rate sensitive stocks should be avoided.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.