Posted on: 31 Jul, 2019
The puzzle is not easy to put together by the Fed, and that’s why it may result in today’s FOMC meeting to conclude that not only a 25bp rate cut was needed as an insurance, but amid such dicey global backdrop and low inflation, it’s best to keep sufficient dovish options on the table.
To our Market Insights
The US Dollar is going to command the attention of the whole financial system as the Federal Reserve is just hours away from updating its setting of monetary policy.
According to the Fedwatch tool by the CME Group, which looks at the probability of an FOMC move on rates, the overwhelming assumption is that the Fed will execute on its well-telegraphed rate cut, but only by a reduction of 25bp, currently standing at a 78% chance vs 50bp, which is assigned a 22% probability only.
Today’s FOMC represents a historical meeting, given that if expectations are ratified by Powell & Co., it will be the first time since 2008 that the Fed will lower interest rates, in what’s been dubbed an ‘insurance rate cut’ to better accommodate the tight US monetary policy to a gloomier global outlook amid low domestic inflation.
It’s important to note that when the Fed officially concludes a tightening cycle, as it’s more likely to be the case in a few hours’ time, it marks a meaningful top and sets the Central Bank out for what’s historically been a prolonged period of lower rates. Therefore, if history is any indication, today’s landmark moment to return to an official easing, even if still debated as a one and done rather than the commencement of a rate-cutting cycle, it runs the risk of morphing into one.
The chart below doesn’t lie. The Fed has nailed it over and over in dialing back to an easing cycle as it forebodes signals of distress in the financial system. However, this time, rather than originated by internal US economic factors, the Fed’s rationale to act lies on waning global slowdown as the dicey trade war takes its toll on business investment intentions (CAPEX) at a time when we see convergence in the overmaturity of both the business and economic cycles in the US.
But it gets more spooky, even if at this point is just anecdotal evidence. The last three recessions all took place within 3 months of the first-rate cut after a hiking cycle.
But I digress. Today, which is what really matters, we need to deconstruct what and how the Fed does in order to gauge the potential ramifications for the US Dollar.
An event that’s probably raised some red flags by Forex traders is the fact that the US Dollar index (USD vs G8 FX) has put on its largest winning streak (8 days) this year, just ahead of the FOMC fireworks. This dynamic is the exact reverse of what we saw last week in the EUR index (vs G8 FX) if you think about it.
The index shows the performance of USD vs G8 FX. An educational article on how to build your own currency meter can be found in the Global Prime's Research section.
Ahead of the ECB, the EUR index had sold off mercilessly for over 2 weeks in anticipation of a big dovish announcement by the ECB, which never came in the degree expected, as the CB failed to flesh out the necessary QE II details the market was waiting for to justify further downside.
In the case of today’s USD lofty valuation, the pre-FOMC run tells us that just as the bar was set high for the ECB to keep the bearish party going, the Fed is going to have to cut the wings from those perma dovish by hinting that this is not a rate-cutting cycle (for now) and probably dismiss the immediate prospects for more cuts in Sept.
At present, there is certainly a disconnect between what the market is discounting and reality. According to market pricing, the Fed is contemplating 100bp of rate cuts by the end of 2020, but the logic seems to defy such action in the very short-term. The bond market thinks Trump’s pressure on the Fed and his trade policies will result in an easier Fed, which in and by itself has proven, along with stock valuations, to be a signal for the Fed to act in what’s seen as “a hall-of-mirrors situation.”
A first crucial clue will come out of the Fed’s updated dot plot graph, which is the method used to convey each member’s benchmark Federal Funds interest rate outlook going forward. How the dots get re-distributed in the chart will have a first initial impact on how the USD react.
Federal Reserve dot plot June 2019
What will be important to watch is whether or not the Fed’s dot plot under or over-delivers in its forward guidance. If the Fed decides to cut rates by 25bp on a unanimous decision, we could initially see a modest USD rally as the market interprets that as a sign that there is a low conviction on delivering a second rate cut at this point.
What would really turbo-charge the USD is if the Fed cuts by 25bp but a minority of the members disagreed by voting to keep rates unchanged. That’s not my central case though, as the line-up of Fed speakers in July has really carried a consistent message about a small cut. Both Kansas City Fed President Esther George and Boston’s Rosengren have been the only challengers expressing their opinion against cutting rates, and if anyone else joins, it will cause more uncertainty (USD+).
Now, if the Fed wants to practice a major "harakiri" by committing the suicidal decision of not cutting rates, not only it’d represent an epic failure in communication, but the USD would go absolutely ballistic as the market scrambles to buy USDs in mass. This is a scenario the market finds as having nil probabilities and I agree.
On the contrary, if a few members dissent by endorsing a 50bp rate cut, which at this point, judging by the raft of Fedspeakers in the last month, looks quite unlikely, then the potential initial move by the US Dollar would be to pull back from the elevated levels it trades from.
A scenario that should not be ruled out, as the 22% Fedwatch tool indicates, is that the Fed does indeed cut rates by 50bp, which is the central case defended by Morgan Stanley’s Research Team. “The worry lies in the US' sharply weakening capex cycle” they note. “We believe that the Fed will be concerned about capex weakness and its impact on productivity/neutral rates, among other solid reasons for our 50 bp rate cut call.” If it turns out to be true, the USD would collapse.
In my opinion, the risk appears to be skewed towards under delivering and a potential USD long-side campaign to get rid off weak-handed shorts ahead of Powell's speech where all bets will be off. This is a thesis that is predicated on the basis of paying attention to all Fedspeakers in July.
To portray the overall sentiment at the Fed, I find it quite revealing that when a perma dovish like Fed St. Louis President James Bullard has ruled out support for more than 25bp this month, really makes you question how on earth we’d get aggressive rate cut calls in near term.
Add to the mixture of reasons the solid US economic data in recent weeks (US NFP, retail sales, core durable goods, US ISM, …) and it fortifies the notion of the Fed under-delivering in it dot plot, with Powell having to later to the heavy lifting by massaging a message that is sufficiently convincing to resonate with residual dovish expectations.
The largest concentration of volatility should come as Fed’s Chair Powell gives his speech and answers journalists’ questions on monetary policy. Since no one really knows how Powell will play his hand under such high wire act context, the communication around how likely it is that further rate cuts follow suit is crucial.
My sense is that the Fed wants to cut more as it recognizes the current interest rate level is out of whack with the perceived neutral rate. The unprecedented shift in the Fed rhetoric into a dovish stance at a time of above-trend economic expansion has found its roots on the anticipation of the knock-on effects of the global troubles to the US economy, hence it has grown uncomfortable and sees a conflict between the backdrop and the US keeping up its growth momentum.
Jerome Powell has been quite vocal alongside his closest confidants Fed’s Clarida and Williams that lower rates are coming due to “uncertainties around trade tensions and concerns about the strength of the global economy continuing to weigh on the US economic outlook”, Powell has stated.
In the Fed view, there are many moving pieces and uncertainties that warrant caution but with the US economy still on a stubbornly solid footing, and the trade war in a bit of a recess as US-China feel each other out on the truce, they must be prepared to act further at any time.
What this means is that for Powell to contain volatility and the rise in the USD, he has to play an ambiguous game by providing evidence, as a unified front, that the intention is not to embark on a protracted easing phase (just yet), but still affording to sneak in hints for another 25bp cut in September or October. That expectation should cap the USD.
If the Fed is serious about doing something to minimize future risks in the US from external factors, alongside contributing to ramp up inflation, I don’t see how a 25bp rate cut will cut it (pun intended), let alone that history clearly tells us that the onset of a rate cut phase barely ever is followed by just a one-off. Again, a hint of a follow-up 25bp cut I think can realistically be expected for the Fed to stay credible to its present concerns, rationalized from a troubled global view this time.
If Powell, instead, resorts to a conditional stance with flexibility as the central rhetoric to adapt to developing economic conditions without making the case for further cuts, that might not serve too well for the case to revert the USD uptrend, and the cost of that would probably be pretty sizeable in terms of the downside in the US stock market with financial conditions also tightening significantly as a result.
Powell must seek out leverage by leaving the door open to act near-term if needed, but the markets aim for meat in the bone (read reassurance), which is why they want enough explicit acknowledgment that the Fed aims to bring the interest rate lower by at least 50bp before re-assessing.
In large part, it will come down to how Trump plays its trade policy card, to how fast a global slowdown may spread into the US economy, to the high levels of the USD which may create further disinflationary pressures and keep missing the Fed target inflation, to the attractiveness of keeping investing by businesses in the US. Quite a jigsaw.
The puzzle is not easy to put together, and that’s why it may result in today’s FOMC meeting to conclude that amid such dicey environment, it’s best to keep sufficient dovish options on the table. That’s why I still think it’s in the Fed's best interest to pre-announce further action in Sept or Oct, which should put a cap on the rise in the USD short-term.
Feel free to get in touch with us to find out more about our service.