The Fed came across as somewhat hawkish relative to expectations, according to Citi's Stephen Englander, but FX made an outsized move against high-beta G10 and EM relative to equities buying and moderate money market moves... here's why...
Via Citi's Stephen Englander,
This contrast may be explained by the benign implications of the Fed’s indicated fed funds path for the US and the not-so-benign implications for other countries.
In the Figure 1 we see the USD moving up by 0.6% vs. G10 currencies (light blue line) in the aftermath of the Statement/Press Conference, the VIX (dark blue) coming off and ending flat, and Dec 2016 eurodollars (purple) selling off. Equities rose initially but ended flat, like the VIX.
To be clear we see the Forecasts/Press Conference as being hawkish and the Statement as being dovish and to be honest we would not have expected such a dramatic FX move from this combination.
So what played out as hawkish?
1. The upward shift in the fed funds path and the downward nudge to expected unemployment rates.
2. Even the doves were hawkish. If you count four dots from the bottom, so you are firmly in FOMC doveland, the June dot was 0.5% for end-2015, now it is 0.88% (yesterday’s Dec 15 fed funds contrast was at 0.74%); the fourth dot from bottom in June was 1.75% for 2016, now it is 2.12% (yesterday’s Dec 2016 was 1.77%); the fourth from bottom Dec 2017 forecast is 3.12% (yesterday’s EDZ7 contract suggested a market expectation of about 2.60-2.65%).
3. Fed Chair Yellen had plenty of opportunity to say ‘ignore the dots, only pay attention to the FOMC’s Statement’ , and if anything she seemed to endorse the dots and the forecasts.
4. She was very emphatic in her data dependence and emphasized the ‘approach the target faster, tighten faster’ side
5. She was than emphatic in optimism on either productivity or labor force growth, viewing flat participation as success because of the downward trend in participation rates, so implicitly she was reducing the size of the output gap
So even with an essentially unchanged Statement, the overall impression was very middle of the road, when investors were looking for her to drive on the left.
Now why the big move in FX and not so big move in other asset markets?
Consider Figure 2 which gives a schematic picture of what may be worrying FX markets. Assume the blue curve gives the distribution of economic/financial market outcomes for the world ex-US, with some risk of terrible outcomes, but most of the risk concentrated in the safe zone. A negative shock such as a backing up of US rates will shift a relatively large part of the distribution into the danger zone. By contrast, the same shock applied to a relatively healthy economy (US or UK, for example, illustrated by the red curve) shifts only a small part of the tail into the danger zone. So even if the Fed comment were equally as hawkish for the US and non-US economies, the onslaught of bad news on China, Japan, Europe etc. may make the outcomes disproportionately bad for them. One bit of evidence is that GBP sold off by much less than other major currencies (although GBP’s lower beta may also be a factor.)
The worst combination for currencies right now is to be a high-beta currency in a slowing commodity-exporting economy with a large current account deficit.