The upcoming FOMC meeting is one of the small meetings without new 'dots' and a press conference. As it is broadly expected that the FOMC will keep the federal funds target range unchanged at 0.25%-0.50%, focus is on the statement. Even though financial markets have taken Brexit very calmly and the US equity market is at an all-time high, we expect the FOMC to take a cautious stance due to possible negative spill-over effects from Brexit uncertainties. Still, risk is tilted towards a more hawkish Fed given the strong rebound in US data in Q2 (especially on the consumer side). Unfortunately, the FOMC statements do not always send the best signals and we will probably have to wait for the following minutes or new FOMC speeches to get more details about how the Fed sees the economic outlook post-Brexit.
We still expect the Fed to be on hold until June 2017 and only hike twice next year (following hike in December 2017). Markets' pricing is even softer as they have priced in just two-third of a hike this year and a total of 1.25 hikes by year-end next year (approximately). However, if it turns out that the US economy continues to grow steadily and the labour market continues to improve despite Brexit, the Fed hiking theme could return for real. Some of the recovery in the financial markets since Brexit has been driven by the expectations of more dovish central banks, as markets among other things have priced out Fed hikes. So if the Fed begins to talk about hikes again soon, markets could respond negatively, which could eventually lead to the Fed postponing again. Since PCE core inflation is still below 2%, inflation expectations (both survey-based and market-based) have fallen and wage inflation is still subdued, the Fed can afford to stay patient.
We expect the FOMC meeting to be neutral for the USD with risks skewed towards a slightly stronger dollar. The 2Y UST yield has room to rise further, which should support the USD. We expect EUR/USD to fall near term with our forecast pencilling in a fall to 1.07 in 3M driven by cyclical and monetary divergence.
US money market rates have moved higher after the recent strong numbers (non-farm payrolls and ISM) and as the US money market reform is moving closer. A FOMC acknowledging the better labour market numbers could reinforce the tendency for higher money-market rates as pricing of rate hikes is still very modest for 2016-18. The global hunt for yield is still keeping a solid lid on longer-dated treasury yields and a further flattening of the 2Y10Y is still in the cards for the next couple of months.
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