How to forecast currencies without the FED’s guidance

Hence, they have applauded new Fed Chair Warsh's decision to scrap guidance, even if it does make the post-meeting press conferences a bit boring. But does it make our job of forecasting currencies and rates all the harder?

Here we are going to focus on currencies, specifically, the US dollar. There seem to be a number of ways that this guidance shift could impact the dollar. The most obvious is that it could generate bouts of significant volatility when ‘surprise' rate changes are announced. Of course, a lack of explicit guidance might not necessarily imply that rate changes will be a complete surprise.

Nonetheless, we should expect more volatility. This volatility clearly seems likely to mean a stronger US dollar when rates are rising, compared to the period of guidance we've seen in the past, but also implies US dollar weakness when rates are surprisingly cut.

Given that the Fed seems to be in rate-hiking mode at the moment, it would seem that this change in emphasis by the Fed is more likely to lift the dollar than lower it. However, it is not as simple as this. The decision to scrap guidance has been designed so that the market comes to its own conclusions about the appropriate policy setting, not just to reflect back the Fed's guidance. But the problem is that the market might suggest a policy setting that FOMC members don't agree with, or at least not on the same timescale as the market.

For instance, the spread between 2-year treasury yields and the top of the Fed funds target is close to 50 bps. It has risen by 90 bps from before the conflict in Iran, which is a very sharp increase indeed. Does this mean that the market is telling the Fed it needs to hike? If so, it was a message that the bank clearly decided to ignore on Wednesday, as it left rates unchanged. Now clearly any Fed member will tell you that, while it is nice to see an unfiltered version of policy expectations from the market, the bank is not duty-bound to follow. Lots of factors go into deciding whether to change rates or not, and this sort of market ‘pressure' is just one input.

Steven Barrow, Head Strategist of the Standard Bank, said the Fed would be well within its rights to disregard it in favour of other factors that might suggest that leaving rates unchanged is appropriate. But the problem is that the market – or at least the dollar bulls (in the case where the pressure is for rate hikes) – may not like it and may show this by selling the greenback. It would seem to suggest that, while the lack of guidance during a rate-hiking cycle might generate more dollar strength when rates are (surprisingly) hiked, as described earlier, this will be counterbalanced by risks of US dollar weakness if the Fed is deemed to be falling behind the curve when rates are left unchanged. Putting the two together, it seems that the net impact of removing guidance is minimal. However, this is not the only aspect worth considering.

For instance, there is the broader issue of whether removing guidance makes policy ‘better'. As you might imagine, we think that it does given that we've argued for many years now that guidance should be ditched. Steven Barrow thinks it will give better outcomes for the same reasons as Chair Warsh, which is that it gives a cleaner read of market expectations. A lack of guidance may also give the bond market more room to adjust and hence do some of the Fed's policy work for it by, for instance, lifting yields when inflationary pressures are building.

Warsh noted this week that the market has done just that as real and nominal yields have risen quite a bit since the last meeting without the Fed changing policy in any way or giving any guidance. No doubt some would argue that it is dangerous to seemingly give the market freer rein, but we don't agree with that, and neither does Warsh. “If this shift makes monetary policy ‘better' then it is more likely to lift the dollar. That's what we think is most likely to happen, although, as we know, this is only one of a number of factors that shifts the greenback around," said Steven Barrow.