EM Rundown: Traders Weigh Fed Announcement vs. Russian Tensions

Emerging market currencies have been generally flat against the U.S. dollar in the first half of this week, but traders are now weighing two near-term catalysts against one another: the Fed and Russia.

Fed Projects Earlier Interest Rate Hikes

Today’s FOMC statement by and large matched up with traders’ expectations; the Fed chose to reduce its monthly Quantitative Easing purchases by $10B ($5B of mortgage-backed securities and $5B of treasuries) and removed its forward guidance (the so-called “Evans Rule”). As anticipated, the bank also reiterated that interest rates will remain low in the short term, stating, “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."

However, there were some modest surprises from the Fed’s “Summary of Economic Projections” to stoke volatility in the market. The central bank revised its 2014 real GDP forecast slightly lower to 2.8-3.0% (from 2.8-3.2%) and its 2014 unemployment rate forecast to 6.1-6.3% (from 6.3-6.6%). The bank also revised its GDP forecasts for 2015 and 2016 modestly lower.

Nonetheless, the market has initially taken the statement as a hawkish sign, primarily because of the Fed’s esoterically-named “dot chart.” This chart shows that the majority of Fed members (represented by dots in the below diagram) expect interest rates to be at 1% or higher by the end of 2015, whereas most members had previously anticipated interest rates would be at 0.75% or lower back in December. For what it’s worth (keep in mind that the Fed’s forecasts have been rather inaccurate of late), the committee appears more confident about the economic recovery than it was three months ago, and traders have bought the US dollar aggressively as a result.

Figure 1:

Source: FOREX.com, Federal Reserve

How Now Russia?

The familiar Russia vs. Ukraine/Western World clash remains a hotspot for the market, though the latest news suggests there could be a potential “light at the end of the tunnel” after the conflict. Though Russian forces stormed into a Crimean military base just yesterday, killing a Ukrainian serviceman, markets were reassured by Putin’s comments that Russia had no plans to enter Eastern Ukraine and that oil would continue to flow through the country to the rest of Europe.

At this point, it seems as if markets are already resigned to Crimea becoming a part of Russia, notwithstanding the potential for further sanctions from the West. The fact remains that many European powers are loath to risk a trade war with Russia, so additional sanctions may be relatively minor and have a limited effect on the economies in the region.

Technical View: USD/RUB

Prior to the Fed announcement, the price action in USD/RUB indicated that the market was betting on a peaceful resolution between Russia and the West. The USD/RUB dropped to a new 3-week low earlier today, breaking a previous strong bullish trend line in the process. The MACD indicator on the pair also hit its lowest level in nearly 2 months, suggesting that the bullish momentum may finally be reversing.

Despite the Fed-induced strength in the U.S. Dollar, a continued moderation in the Russia/Ukraine conflict could continue to push USD/RUB lower as we move through this week, with a break below the 23.6% Fibonacci retracement potentially opening the door for a drop to the 38.2% Fibo at 35.20 next. On the other hand, a re-escalation of tensions could take the USD/RUB back toward last week’s highs (and the all-time high) upper-36.00s.

Figure 2:

Source: FOREX.com