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Will the Fed Omit Patience and Push the Euro to Parity?

  • Investor’s focus on FOMC Wednesday
  • Will the Fed drop “patient” from its statement?
  • Euro parity sooner rather than later
  • Fed needs to give investors time to adjust

The Federal Reserve will take center stage this week. It is not the only central bank that is expected to have an impact, but it will be the most significant.

The Bank of Japan concludes its two-day policy meeting on Tuesday while the Bank of England is due to publish its latest policy meeting minutes on Wednesday. U.S. manufacturing and housing data will also be keenly watched this week as both have disappointed in recent months with barely positive average numbers. The key reports are this morning’s industrial production (+0.1% versus +0.3% expected, month-over-month) and tomorrow’s housing starts (expected +1.03 million). Quadruple witching takes place Friday but market moves are likely to start Thursday in preparation.

Over the past 18 months, Fed Chair Janet Yellen and her fellow policymakers has been the dollar bulls’ greatest ally. Will U.S. policymakers be able to deliver or disappoint them come midweek? Investors on Wednesday will be carefully analyzing the statement the Fed releases following its two-day meeting and Yellen’s post-meeting news conference for any hints on when the bank might start raising interest rates.

To date, the market seems evenly divided with 50% expecting a rate “liftoff” to commence in June, while the remainder is backing a September hike. If the Fed drops the word “patient” from its statement on the timing of an interest rate rise, this could pave the way for a move as early as June, adding fuel to the dollar’s surge against the major currencies. The danger is that dropping “patient” from the communiqué would not necessarily mean that the first rates hike would commence in June, despite the U.S. outlook for employment and activity being healthy enough to merit it.

Rate Trajectory to Be Low

Whenever the Fed does begin to tighten, the course of rate hikes should not be steep. Yellen needs to be flexible, and with U.S. inflation well below the +2% target, the Fed can afford to impose incremental changes so it can pause if the U.S. economy shows any signs of softening. The reality is that beginning rate normalization is not to cool an overheating U.S. economy, but to start the ball rolling to get a near zero rate policy up to the desired “normal” rate of +3.75% that the Fed deems appropriate. Once this process starts, recalibration of the various asset classes will begin in earnest, but not like the stop-start that we have seen from U.S. bond yields and equity prices over the last little while. February’s strong nonfarm payrolls report certainly strengthened the argument for a June rate hike. This immediately put U.S. equities under pressure. While last week’s disappointing U.S. retail sales report (the third consecutive negative report) managed to push the timing for some out to September or beyond. This has allowed equities to rally.

Expect Dollar Parity Within a Year

The rate divergence argument has many analysts rejigging their timing on when the EUR will be trading on par to the U.S. dollar. Since the inception of quantitative easing in the eurozone last week, the single currency crumpled under intense pressure (€1.0464), allowing the mighty USD to continue to rack up multiyear highs across a number of currency fronts. The negative or low-yield scenario throughout the eurozone is not an incentive for investors to hold the EUR. Many portfolio managers want to hold value and receive a return. Negative yields and a currency under constant pressure have investors seeking U.S. assets. The possibility of the Fed beginning its rate normalization rate cycle in either the first or second quarter could easily push the EUR to trade one-on-one or below within a matter of months.

For investors, the dynamics of the various asset classes are wrong. Even after their recent pullbacks, equities look expensive. The S&P 500 is trading at 17 times expected earnings, up from 15 a year ago. The same scenario with U.S. Treasury yields. Long-term yields are much lower than a year ago, even with the threat of a Fed rate hike cycle commencing. The directional play has been one way because of central banks’ monetary policies. Are investors prepared for a whiplash? The Fed cannot afford to get their timing wrong; going too soon could stymie current growth, while not being proactive could cause various asset bubbles and a potential problem with inflation.

The Fed is walking a fine line, while investors are not necessarily prepared for the worst. Do not be surprised to see the Fed keeping a June tightening on the table as long as possible so that the market can make the necessary portfolio adjustments. No one wants to see a shocked market reaction that may derail all the good that has been done so far to date. Once this has been achieved, then the Fed does have the latitude to move further out the curve citing data dependent reasons.

Forex heatmap

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Dean Popplewell

Dean Popplewell [5]

Vice-President of Market Analysis at MarketPulse [6]
Dean Popplewell has nearly two decades of experience trading currencies and fixed income instruments. He has a deep understanding of market fundamentals and the impact of global events on capital markets. He is respected among professional traders for his skilled analysis and career history as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006, Dean has played an instrumental role in driving awareness of the forex market as an emerging asset class for retail investors, as well as providing expert counsel to a number of internal teams on how to best serve clients and industry stakeholders.
Dean Popplewell
Dean Popplewell

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