The Signal: USD Risk-Reward Into FOMC - BofA Merrill

The Signal: USD Risk-Reward Into FOMC - BofA Merrill

26 April 2016, 16:19
Vasilii Apostolidi

Markets are pricing nearly no chance of a Federal Reserve rate hike over the next few meetings, and less than one full hike by the end of the year (Chart of the day). Near-term weakness in US activity data and cautious comments from Fed Chair Janet Yellen have reinforced this view. Yet global economic and financial conditions have generally stabilized if not improved, and we expect further progress toward the Fed’s dual mandate objectives over the coming months.

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As a result, we think the Fed will likely hike rates again this summer, potentially in June if the global market selloff ahead of the Brexit vote is limited. Otherwise, we still see a good case for the next hike in July. Either way, we believe the Fed will have to start preparing the markets for a possible rate hike at an upcoming meeting this summer.

With no press conference or forecast update at the April Federal Open Market Committee (FOMC) meeting, focus will be on the statement language. The FOMC will likely acknowledge the weak data to start the year, but contrast with expectations for continued gradual progress toward full employment and the inflation target.

The Committee may note global risks have dissipated slightly, or that the disinflationary effects of the US dollar or commodity prices have started to ease. Some signal of this type could help to modestly lift the market’s assessment of rate hike likelihood. More explicit language or guidance would be more powerful, but also a low-probability outcome, in our view.

FX: Waiting for a tone change

The April FOMC meeting is unlikely to change the dollar’s near-term trajectory with the market pricing zero chance of a shift in policy this week. The dollar’s broad decline since the March FOMC is contributing to an easing in financial conditions that could engender a slightly more optimistic tone on global financial conditions and the risks they pose. With less than a 20% chance of a June hike currently priced, this language change could provide modest, though unlikely sustained, USD support.

A continued data-dependent stance, which leaves open but does not strongly signal June action, may limit USD downside, but it will not push it higher until the prospects for a June hike become clearer.

With the market not pricing the next full hike for nearly 12 months, combined with flat USD positioning, risk/reward favors tactical USD longs should the tone from Fed officials turn more optimistic between now and June, as we expect.

But, as we have argued, the Fed’s cautious tone and comfort being behind the curve on inflation is a headwind for the USD as real yield differentials are unlikely to move significantly in the dollar’s favor. Additionally, increased expectations for Fed hikes could refocus market attention on China at the expense of risk appetite and counteract the USD-positive impact of higher yield differentials.

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