When China transitioned to a new currency regime last month, what should have been immediately apparent to everyone, was that the Fed was, from there on out, cornered. Boxed in. Trapped. 

We reiterated this earlier today as the market still seems to be quite confused as to what exactly happened that caused Janet Yellen to resort to what many thought was the most unlikely option going into this week’s meeting: the “dovish hold”, or, as Deutsche Bank recently called it, the “clean relent.”  

What follows is a recap of just how we got to this point or, in other words, an explanation of how the FOMC missed its opportunity and became trapped in the wake of China’s move to devalue the yuan. Following the recap, we present excerpts from Citi’s take on the Fed’s “new reaction function. For those familiar with the backstory and/or who have a good grasp on why it is that the Fed went the route they did, feel free to skip straight to the section from Citi and the subsequent discussion.

How did we get here?

Despite all the ballyhooing about moving to a more market-based exchange rate, the PBoC actually did the opposite on August 11. As BNP’s Mole Hau put it “whereas the daily fix was previously used to fix the spot rate, the PBoC now seemingly fixes the spot rate to determine the daily fix, [thus] the role of the market in determining the exchange rate has, if anything, been reduced in the short term.” Obviously, a reduced role for the market, means a greater role for the PBoC, and that of course means intervention via FX reserve drawdowns (i.e. the liquidation of US paper). Of course no one believed that China’s devaluation was “one and done” which meant that the pressure on the yuan increased and before you knew it, the PBoC was intervening all over the place. By mid-September, PBoC intervention had cost some $150 billion between onshore spot interventions and offshore spot and forward meddling.

The problem – as everyone began to pick up on some 10 months after we announced the death of the petrodollar – is that when EMs start liquidating their reserves, it works at cross purposes with DM QE. That is, it offsets it. Once this became suddenly apparent to everyone at the end of last month, market participants simultaneously realized – to their collective horror – that the long-running slump in commodity prices and attendant pressure on commodity currencies as well as the defense of various dollar pegs meant that, as Deutsche Bank put it, the great EM reserve accumulation had actually begun to reverse itself months ago. China’s entry into the global currency wars merely kicked it into overdrive. 

What the above implies is that the Fed, were it to have hiked on Thursday, would have been tightening into a market where the liquidation of USD assets by foreign central banks was already sapping global liquidity and exerting a tightening effect of its own. In other words, the FOMC would have been tightening into a tightening.