The upcoming US FOMC meeting is likely to be a critical event in setting the US dollar’s overall trend in the weeks ahead. However, despite a relatively low chance of an April rate hike, it’s probable that the dollar will rally…and here is why.
Inflationary Expectations
The Federal Reserve has taken great pains to emphasise their plans to embark upon a normalisation plan in line with inflationary expectations. Subsequently, markets have been keenly watching the headline rates for any indication as to the central banks direction in the April meeting.
Although inflation is yet to reach the central banks 2.00% targeted rate, monthly CPI reporting has proved to be relatively robust coming in at 1.4%, 1.0%, and 0.9% for January, February, and March respectively. Compared to 2015, these results are significantly stronger and support the Fed’s view that inflationary prospects are improving in the near term.
In fact, markets are signalling a medium term inflationary rate of 1.55% if you compare the 5-Year TIPS and 5-Year yield rates. Although, that’s still a fair way below the Fed’s target, it’s likely to be seen as close to where they want the rate to be if you exclude the historically low crude oil prices.
Subsequently, there are plenty of arguments for the hawks upon the FOMC for hiking at the earliest possible point. There is most definitely a view amongst the hawks that inflationary pressures are coming and the central bank needs to get ahead of the curve.
Global Financial Conditions
The strongest reason for the Fed not raising rates so far in 2016 has been the current financial conditions within markets. Generally when you hear rhetoric on these lines it is referring to the US stock market and its recent predilection for declines. However, the risk of a strong bear market has arguably receded since early February as the S&P 500 index has clawed its way back above 2080.00.
In addition, the Fed also arguably sees a stabilisation in China’s domestic economy which also removes some of the risk associated with slipping global growth. However, there are some concerning signs within the Chinese debt markets that is likely to flow into their GDP growth rates in the medium term. Regardless, the Central bank is likely to disregard some of these factors in preference for a more short term view on US domestic inflation.
Subsequently, given that there has been improvement in both the US equity outlook, and the issues with Chinese stability, hawks have plenty to argue in their favour for a more restrictive monetary policy.
US Labour Markets
One of the most watched metrics is US employment and the numbers have recently showed s sharp predisposition to growth. Except for a lacklustre return of 168k, the Non-Farm Payroll (NFP) results have demonstrated robust growth since October of 2015. In fact both the February and March results showed job numbers growing by 245k and 215k respectively. In addition, the US Unemployment rate, which is hovering near 5.0%, is relatively close to what is the natural rate of unemployment for the nation. This is likely to provide additional powder to the hawks in any federal funds rate debate.
However, there is some concern around the currently absent wage inflation given that average hourly earnings rose just 0.3% in March. Given the relatively strong job market it is therefore surprising that there has been little in the way of wage inflation seen following such strong employment numbers. There has therefore been some criticism that the job numbers have been largely skewed by part time job creations.
The Fed’s Credibility is in Tatters
The market waited throughout most of 2015 for the Federal Reserve to take decisive action upon interest rates. It was only in December that we finally received the requisite 25bps hike before the rhetoric returned to a “data dependant” state. Subsequently, it appears that we have largely returned to the will they/wont they discussion and endless periods of waiting for normalisation.
In addition, despite the Fed continuing to promote the view that there would be at least 2 rate hikes for 2016, the market has only priced in this eventuality at around 60%. It would therefore appear that markets have largely shrugged off the central bank’s expectation setting exercises which points to the institutions credibility problem.
It is clear that markets are largely sick of the hurry up and wait rhetoric and no longer accept Janet Yellen’s statements at face value. Subsequently, given the institutions demands to be taken seriously, there is additional face to be gained by decisive action. Failure by the Fed to start the normalisation process in 2016 could therefore see the bank relegated to laughing stock and their loss of the critical expectations channel.
Meeting Outcome and How to Position
It is likely that volatility will be relatively subdued in the lead up to the meeting given the strong expectation that there will be no rate hike in April. However, although the meeting is unlikely to result in a change to the FFR, a hawkish tone from the FOMC is likely. Subsequently, expect a ramp up in rhetoric from the Fed for monetary tightening in June. A statement along these lines would ignite a bullish US dollar rally that would strongly impact commodity currencies. Therefore, look for the Aussie and Kiwi dollar’s to rally sharply following the meeting. However, largely avoid the USD/JPY given that there is a chance of further easing from the Japanese central bank this week.
Ultimately, the FOMC can be hellishly difficult to predict but the signals are strongly pointing to no action in April, coupled with a definite hawkish bias. Subsequently, it’s likely to be a busy week for the US dollar given the need to reassess the Fed’s potential direction.