The latest FOMC Meeting Minutes have taken the shine off the US dollar as the committee makes no indication on whether they will hike in September. With such a weak inflation outlook, is the committee going to agree on a rate hike? And what does that mean for the USD?
For the previous 14 months the market has been heavily on the long side of the US dollar trade. Ever since tapering of the QE programme looked like coming to an end, the market has been bullish on the US dollar index, driving it up from under the 80 mark to the highs of 100.765 seen in March this year. It is still hovering in the high 90s with the prospect of a rate rise ever looming. But change is in the air.
The minutes from the latest Federal Open Markets Committee (FOMC) have taken the shine off the US dollar as the market sees the chance of a rate hike diminish. The drop in the US dollar after the release was not dramatic, but the shift in the sentiment is palpable. The market is becoming concerned that a rate rise in September may not occur and it now views the probability at 35%, down from 46% earlier this week and 55% two weeks ago.
The minutes said "Most judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point." The conditions they are referring to is based on employment, which is the only metric showing any strength at the moment. The minutes went on to say "Almost all members ... would need to see more evidence that economic growth was sufficiently strong and labour market conditions had firmed enough for them to feel reasonably confident that inflation would return to the committee's longer-run objective over the medium term."
Let’s look at that inflation. Core CPI was released shortly before the minutes and fell from 0.2% to 0.1% m/m. Oil, which plays a big part in US inflation figures has fallen sharply once again to touch a fresh six year low at $40.60 a barrel as inventories build once again. The outlook for Oil is pretty grim, which means the outlook for inflation is also grim.The Fed is going to have a tough time selling a rate hike with near flat inflation.
The Fed also made mention of the risks coming from China. “Several participants noted that a material slowdown in Chinese economic activity could pose risks to the U.S. economic outlook.” A spill over from the plunging stock market in China into global equities is a possibility and a risk the Fed will be watching. Certainly the devaluing of the Yuan will pose a risk to US manufacturing exports and US inflation via cheaper imports.
This line from the minutes tells all: “…it would be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labour market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”
If inflation remains flat, as it looks likely to, we will not see a rate hike in September. That will weigh heavily on the US dollar which was bid up on the prospects of a 2015 “liftoff” in rates. It is only a matter of time before all those long positions will need to be unwound, and the shorts will take over.