Investors and traders across different asset classes are eager to know what the Fed is currently thinking, as U.S. equities sit at record highs, the U.S. dollar is close to November 2016 lows, and treasury yields are in a downtrend move.
The question today is not whether the Fed will hike rates or not, but whether the Fed will acknowledge a weak first quarter. Will the tightening pace be interrupted? Are they going to hint towards reducing the balance sheet? Although many questions will remain unanswered in a cautiously drafted statement, any minor tweaks will have a considerable impact on financial markets.
It’s very important to realize that U.S. data saw more deterioration than improvement since the Fed last met on 14-15 March this year. Headline inflation moved away from the 2% target in March with the PCE price index falling 0.2%, marking the first decline since June 2016. Consumer spending, meanwhile was flat, suggesting that higher consumer confidence did not translate into more spending. Although I’m not an expert in the Auto industry, automakers reporting a fourth straight monthly decline in new cars sales is also not a good indication of consumers’ behavior.
Although the Fed does not depend on one set of data, recent indicators should provide sufficient justification for policy markets to move into the defensive.
The most sensitive currency pair today is USD/JPY. The pair has so far appreciated by more than 3.6% from April’s low, and is currently trading at 112. I’ll be closely watching the yield spread on the 2-Year and 5-Year treasuries for the next move. The gap between the two bonds has been narrowing since early March, and if the downtrend resumes after an initial pause, then USD/JPY could find a short-term top at 112. However, if today’s Fed statement ignores the weakness in recent data, the pair may be headed above 113.
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