Caping The Long-Term Yields

The December Federal Reserve (Fed) meeting will seal the faith of the US dollar for the short and medium-term. One of the reasons why the US dollar is so weak is due to the market’s expectations of what the Fed will announce in December. 

The Fed made some huge changes already to its monetary policy mandate. While it remains focused on price stability, the Fed changed the definition of inflation. More precisely, since August, the Fed targets average inflation instead of a certain level.

December Operation Twist

There is increased chatter in the market that the Fed will engage in a so-called Operation Twist starting with December. Effectively, it means swapping short-term Treasuries for ones with longer maturity. The aim is to extend the maturity of the Fed’s portfolio. Therefore, the Fed will manage to cap the yields even more, and to keep the easing conditions ongoing.

Another thing that the market fully priced in is an increase in the Quantitative Easing (QE) program. The current pace set by the Fed is $120 billion/month, and rumors are that the Fed will move to $160 starting with December.

By capping the long-term yields and letting inflation run higher, the Fed will further put pressure on the US dollar. While other central banks in the world eased or are expected to ease some more, the dollar’s decline continues suggesting that the market still believes the Fed may ease some more. Any disappointment from the Fed at the upcoming December meeting should trigger a bounce back in the US dollar.

Last week brought the nomination of Janet Yellen, the former Fed Chair, as the head of the Treasury. In other words, it is fair to assume that the cooperation between the Fed and the Treasury will increase during Biden’s administration, leaving no room for divergent opinions.

At a time when fiscal policy is as important as monetary policy, the fact that a former Fed Chair is the head of the Treasury may be viewed as an extension of the Fed’s powers. Market participants already know that when it comes to the Fed, nothing should be discounted. Even when there seems to be no more room for easing, the Fed always was the power to come up with something new.

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Disclaimer: None of the content in this article should be viewed as investment advice or a recommendation to buy or sell. Past performance/statistics may not necessarily reflect future ...

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