Federal Reserve set to taper its QE programme

Most major currencies have traded within relatively narrow ranges so far this week, ahead of what bodes to be a very busy and potentially highly volatile few days in the foreign exchange market.?

Three of the G10 central banks will have announced their latest policy decisions by the time the week is out, namely the Reserve Bank of Australia, Federal Reserve and Bank of England. Despite removing its view that rate hikes were unlikely until 2024, the RBA fell short of investor expectations yesterday, sending the Australian dollar lower against most currencies. Tonight’s FOMC meeting is expected to be a highly important one for financial markets. The Fed is still a good few months away from raising interest rates, although it is overwhelmingly expected to announce a tapering of its quantitative easing programme today as it attempts to rein in the recent spike in US inflation.?

We expect the unwinding in the pace of net asset purchases to be a relatively gradual one. The Federal Reserve is currently adding approximately 120 billion dollars worth of assets to its balance sheet every month as part of its QE programme, $80 billion in US Treasuries and $40 billion in mortgage-backed securities (MBS). We are in agreement with the general consensus, and think that these net purchases will be reduced by a total of $15 billion a month ($10 billion in Treasuries and $5 billion in MBS). With a taper announcement fully priced in by the market, the US dollar reaction is likely to hinge on the pace and timing of stimulus withdrawal. A faster pace of QE unwinding that brings hikes into view in mid-2022 would be a bullish signal for the dollar, while a more cautious tapering path than that laid out above would likely see it sell-off sharply.?

Will the Bank of England raise interest rates tomorrow?

Investors will have little time to catch their breath before tomorrow afternoon’s Bank of England meeting, which is also expected to be a highly important one for markets, the pound in particular. The vote on interest rates is expected to be a close call on Thursday. We expect Governor Bailey to join Saunders and fellow hawk Dave Ramsden in voting for an immediate rate increase, with chief economist Pill and Deputy Governor Broadbent possibly following suit. The remaining members of the committee lie more on the dovish side of the scale and are, therefore, likely to vote in favour of no change. Either way, we expect a very tight 5-4 or 6-3 vote, with heated discussions to be had among the MPC as to the nature of the recent jump in inflation and the bank’s ability to influence it.?

Market expectations going into the meeting remain lofty, with a 15 basis point hike fully priced in. A vote in favour of no change in rates on Thursday would, therefore, be viewed as a significant disappointment for markets, and would likely trigger a sell-off in the pound. A close vote, with rhetoric that indicates a December hike is on the cards would, however, likely minimise the move lower in sterling. On the other hand, the currency reaction to a vote in favour of an immediate increase in rates would likely be dependent on both the nature of the voting split, and the bank’s comments on future policy. We think that sterling could also come under a bit of selling pressure should the BoE raise rates, but push back on market pricing for hikes in 2022.?