The three week rally in the USD Index continued on Friday as FED chief, Janet Yellen, endorsed the notion of higher US rates in “coming months” and that growth in wages has finally caught up to the growth in the general labor market.
The shift in expectations for the resumption of the FED’s normalization of US interest rates has played an integral role in the recovery of the USD. And while a few FED officials have pointed to the UK referendum on June 23rd as a foreign threat, there have been several recent changes to open market pricing which suggest the FOMC is ready to move on rates sooner, rather than later.
As a rule of thumb, FX traders look at the short-end of the Treasury yield curve to gauge whether the trajectory of rates is suitable for a lift in the Federal Funds rate. In this respect, the implied yield of the August FED Funds futures contract has risen by 15 basis points since May 1st, while the US 2-year note yield has moved 20 basis points higher over the same period.
These data are widely published and fairly easy to follow even for novice investors. However, since the FED began its tapering operations back in October 2014, one of the most fundamental perquisites of the normalization process has been a contraction in the FED’s balance sheet.
The main open market policy tool for the FED to drain excess reserves from their balance sheet is called a Reverse Repurchase agreement, or “reverse REPO.” Since these agreements are transacted directly between the FED and FED approved commercial banks, the data can only be sourced from the Federal Reserve website and after the agreements are transacted.
As a point of reference, from October 2015 until the FED lifted the FED Funds target on December 16th, reserve balances at the Fed fell by $180 billion. Since the end of March 2016, reserve balances have fallen by over $120 billion; largely from reverse repos. And while this is not as large as the decrease that took place before the December normalization, it appears significant enough to claim that the FED does seem to be preparing for an upcoming increase in the Federal Funds target range.
As such, we suggest a long USD bias over the medium and longer term as the divergence of the US rate trajectory continues to move away from the rest of the G-7 Central Bank policies.
Author: Leon Hinde
Leon has been working in the financial services industry for 18 years in management and advisory roles. Leon has extensive experience in general advice and dealings involving securities and derivative financial products.
PS 146 Securities & Derivatives, ADA 1 & 2 accreditation, Responsible Manager Certificate. Leon is authorised to provide financial product advice and deal with respect to the following financial products:
· Deposit Products
· Interest in managed investment schemes; and
· Government debentures, bonds and stocks