Central Bank thoughts have the dollar under pressure: Yesterday’s Fed minutes have certainly lengthened the odds for a rate hike this year. The dollars six-month bull ride in particular has been based on rate differentials, but now, the one-directional lay up trade is in danger of been firmly broken; the markets risk-on sentiment continues to gain traction after dovish interpretation of both the Fed and BoE minutes this week.
The Fed held off raising short-term interest rates at last month’s FOMC meeting because they were not convinced that inflation was robust enough to warrant tighter monetary policy. Adding pressure to Ms. Yellen and company has been the IMF and World Bank, two institutions who have been vocal about the potential for another global recession and the possibility of further financial instability.
Say one thing and do another: The Fed’s credibility has been called into question now that U.S policy makers seem to have backed themselves into a corner. It appears that they have missed their window of opportunity to begin rate normalization without any fuss. In hindsight, the Fed had the ideal occasion to hike in the pre-summer months from a fundamental perspective, however, global events and U.S data since then do provide some compelling reasons to be rate hike prudent.
U.S jobs data last week showed that private sector hiring cooled in August and September. This has introduced further market uncertainty about whether the U.S economy has fundamentally slipped down a gear amidst slow global growth and a strengthening dollar. We can expect the stronger dollar argument and its effect on exports to be gaining even more traction over the coming months.
The Fed has twin goals of a robust labor market and low, stable inflation: U.S job market does not seem to be the problem as it is running near full employment at +5.1%. Inflation, however, remains the long-term issue beneath the +2% Fed target. The inflation run rate has been registering well below the Fed’s target for the past three-years, and is expected to be held down over the coming months because of the strong dollar – which depresses import prices – and declines in crude and other commodity prices.
The Fed’s get out of jail card: Despite the Fed focusing on inflation and unemployment reasons to begin rate normalization, some officials are also worried about financial imbalances. It is certainly a real threat and provides a plausible argument to gradually tighten monetary policy sooner.
However, the Fed’s real problem continues to lie in communication. In the summer, officials signaled they could move in September. They did not, and have since said they expect to act before year-end. The tone of yesterday’s minutes, however, would suggest much later. This market uncertainty is good for intraday volatility, especially the dollar, against emerging market and commodity sensitive currencies. They have born the brunt of the pressure from rate differentials and global growth concerns. China data stabilizing is also expected to help (AUD, CAD, NZD). The reaction from the fixed income market has been minimal; bond dealers have already repriced their Fed tightening expectations since last week’s jobs report (Oct. +3%, Dec. 28% and Mar +52%).
Range bound pitfalls: With the lack of new trading cues, the EUR is in danger of being stuck in a tightly contained trading range for most of Q4. So far, €1.1100 and €1.1500 are not under threat. The single unit movements have more to do with risk-on or risk-off trading strategies (directionless trades) rather than CB influence or fundamentals. EUR bulls should perhaps focus on Volkswagen. Whatever penalty and costs they will burden will have a material impact on Europe’s largest economy and eventually the EUR. On the back of the Fed minutes, and aided by better-than-expected French production data, the EUR has managed to hit a three-week high (€1.1353) in the overnight session.