Why the Federal Reserve’s Tapering Talk Could Test Dollar Bears Further

-Fed’s taper talk vindicated by U.S. outlook but may test USD further.
-Taper contemplation may be an attempted reminder of independence.
-FOMC warning against assumption Fed will print to Congress’ order.
-As Democrats promise huge spending & former chair joins Treasury.

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The Dollar softened on Tuesday as stocks and bonds stabilised although the danger is that Federal Reserve (Fed) chatter about a tapering of its quantitative easing programme continues in the coming weeks and further tests investor sentiment as well as the market’s bearish outlook for the greenback.

Dollars were sold again in the wake of Monday’s falls in the stock and bond markets which had elicited profit-taking on investors earlier wagers against the greenback and a further safe-haven bid for the U.S. currency, with price action coming as a rally in U.S. government bond yields slowed.

Yields have risen sharply in the last week, boosting the Dollar in the process, due to a combination of political developments and remarks from a number of Federal Open Market Committee members who will collectively decide U.S. interest rate and other monetary policies in the year ahead. 

Last week’s Democratic Party victory in the Georgia State election has been a gamechanger for the Dollar in some respects because it gave the former opposition an absolute congressional majority and the incoming President Elect Joe Biden greater freedom to implement his agenda.

“Officials are talking up tapering of bond purchases by the end of the year, no doubt in part thanks to expected loosening in fiscal policy. Several have suggested that mass vaccinations and expansionary fiscal policy could see the FOMC start to discuss reducing its $120bn-a-month asset purchase programme later this year,” says Neil Wilson, chief market analyst at Markets.com. "Any sense the Fed will pull away the punch bowl is apt to weigh on equity markets."

Above: 10-year U.S. government bond yield with Fibonacci retracements of 2020 fall and 30-year yield (blue).  

A Democrat Congress likely means much higher spending and debt issuance than would otherwise be the case, which investors have so-far assumed will be automatically lapped up by Fed bond buying that has closely matched extraordinarily increased spending through the pandemic.

Matching the extraordinary demands of the public the purse had been necessary to preserve “market functioning” but with multiple vaccines now being rolled out in the U.S. and elsewhere, light is at the end of the lockdown tunnel and some policymakers are contemplating when might be appropriate for the Fed to step back from the market. 

"Amid rising inflation expectations and equity prices, Fed officials have begun to be asked about the possibility of tapering. For now, they highlight that it’s too early, but as the risk rally in part is built on Fed dovishness, Fed-speak is worth watching closely," Rui Ding, a strategist at Citi FX. "Our trading desk acknowledges that the selloff in US FI as a risk and therefore continue to hold long USDJPY as a hedge to our overall USD shorts."

Above: U.S. Dollar performance against major currencies in the week to Tuesday. Source: Pound Sterling Live. 

Such deliberations are both natural and inevitable but the danger for the Dollar bearish market is the Fed now sees these as an urgent matter of necessity, both for the sake of demonstrating its independence as well as pre-emptively heading off a more destabilizing adjustment in yields further down the line. 

The appointment of former Chair Janet Yellen to the role of Treasury Secretary in Joe Biden’s administration may otherwise give the impression of too close a relationship between the Fed and Treasury. This would then risk driving U.S. yields much lower than would otherwise be the case only for an eventual disappointment to prompt a ‘taper tantrum’ that is larger, more palpable and destabilising of the markets than is necessary.

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A taper tantrum would lift the Dollar and U.S. yields just like last week and in earlier episodes, weighing on other currencies in the process.

“The US Dollar Index is upside corrective and we are near term looking for a correction to the downtrend at 91.72. We had warning signals last week – the divergence of the daily and now the weekly RSI and warning signal number two was the TD perfected set up on the weekly chart,” says Karen Jones, head of technical analysis for currencies, commodities and bonds at Commerzbank. “EUR/USD has divergence on the WEEKLY RSI and we would allow for a retracement to the 1.1936 2020-2021 uptrend.” 

Above: U.S. Dollar Index shown at daily intervals alongside Euro-to-Dollar rate (blue).

Federal Reserve Bank of Dallas President Robert Kaplan, a non-voter on the FOMC this year, said Monday that he’s hopeful the Fed will be able to taper later in 2021. This was just hours after Federal Reserve Bank of Richmond President Thomas Barkin, who is a voter on the FOMC this year, said the timing of any tapering is “a consideration” for him.

The most ‘hawkish’ remarks arguably came from Federal Reserve Bank of Atlanta President Rafael Bostic, who said Monday he isn’t “super concerned” about recent increases in yields. He did qualify his message when saying any decision to taper could only come after “strong moves” in unemployment, inflation and virus control, although this was only after telling Fox Business last week that tapering could come sooner than markets expect.

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That sentiment that was backed by Federal Reserve Bank of Chicago President Charles Evans who said “...we could end up doing some kind of tapering,” if U.S. economic outcomes prove stronger than the bank currently anticipates. 

“Interestingly, despite the very strong USD bearish consensus, the consensus on economic forecasts already shows the US as one of only two major economies expected to end this year larger than it started last year (i.e. only one of two economies alongside China where consensus already expects the pandemic effect on growth to be wiped out by the end of this year). That underpins our 2021 outlook for USD, which is at odds with the bearish consensus. We think better economic performance in the US will translate into a cyclical advantage for USD vs non-commodity producing G10 in particular,” says Elsa Lignos, global head of FX strategy at RBC Capital Markets. 

Above: AUD/USD shown at weekly intervals alongside NZD/USD (blue).  

While other FOMC rate setters like Vice Chair Richard Clarida have generally taken a more cautious approach, a number of others have now come out warning the bank could begin stepping back from the bond market sooner than investors anticipate. 

The timing of this is curious because U.S. cities and states are increasingly being subjected to renewed restrictions on activity owing to a third wave of coronavirus infections that not vaccines could prevent from damaging the economy and lifting unemployment further at least in the early months of 2021.  

"A rebound in the USD, along with a rally in US treasury yields has put renewed pressure on spot gold prices, with the market now trading well below US$1,850/oz," says Warren Patterson, head of commodities strategy at ING. "Meanwhile, last Friday Joe Biden called for fiscal spending and said, ‘it will be in the trillions of dollars’. Hopes for spending in clean energy and infrastructure will likely increase investor appetite for metals."

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The Fed had only just updated its guidance in December with a statement saying its bond buying would continue until "further substantial progress been made" toward its full employment and 2% inflation goals, which had been interpreted by the market at the time as an attempt to assure investors of continued policy support this year.

In the summer of 2013 stock and commodity markets slumped while the Dollar and bond yields rallied after the Fed indicated it could soon wind down its post-crisis quantitative easing programme. The subsequent fallout has since been referred to as a ‘taper tantrum,’ but this year’s surge in U.S. yields and the Fed’s role in it might serve as a warning to bond investors that they aren’t the only ones who can throw taper tantrums.

"For now, we’ll treat this as a tactical theme given that the long-term structural factors that are bearish USD haven’t dissipated. Also, a decline in the long-end of the UST curve has a shelf-life. For instance, if it continues, then equities should ‘trip’ further which could lead to the Fed sending out dovish messages," says Bipan Rai, North American head of FX strategy at CIBC Capital Markets. "The levels we’ll be eyeing are 1.20 for EUR/USD. A break below that means that the corrective move is deeper than we may have thought. For USD/CAD – that means a break above the 1.2930-1.3000 range."

Above: Pound-to-Dollar rate shown at weekly intervals alongside USD/CAD (blue).