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Forex - US Dollar: Will the Federal Reserve's Meeting Yield A Bullish Breakout?

The US dollar has been rallying against the world’s most heavily traded currencies on speculation the United States Federal Reserve could open the door for a series of rate hikes in the months ahead. However, with the US economy remaining fragile, is there a chance that the Federal Reserve could disappoint and hurt the US dollar?

The US Dollar Has Been Appreciating But Could the US Federal Reserve Disappoint?

The US dollar has been rallying against the world’s most heavily traded currencies on speculation the United States Federal Reserve could open the door for a series of rate hikes in the months ahead. Indeed, the US dollar is trading close to a one month high against the euro and has been appreciating sharply against the Japanese yen. Yet, the chances of the Federal Reserve increasing rates by 25 basis points at this August meeting are below 7 percent. In fact, even though real GDP growth picked up to a 1.9 percent annual rate, the U.S. economy remains very fragile and the recent spike in economic activity only reflects spending out of tax rebates. Moreover, traders expect the Federal Reserve to increase rates by 75 bps over the next eight FOMC meetings, according to overnight index swaps which measure interest rate expectations for the next twelve months. Nevertheless, the US Federal Reserve may disappoint and hurt the U.S. dollar.

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US Economic Data:  How Have Things Changed Since the Last Meeting?

Since the Federal Open Market Committee (FOMC) last met in late-June, economic conditions in the US have evolved in a less-than-favorable way. While GDP rose to a 1.9 percent annualized pace in Q2 from 0.9 percent in Q1, this was simply an advanced reading and could be revised two more times. Highlighting the importance of this factor, Q4 GDP was revised just last week down to a dismal -0.2 percent from 0.6 percent. Additionally, more timely indicators of economic expansion point to a slowdown. On the consumer front, personal spending, personal income, and advance retail sales all slowed dramatically in June following a post-rebate check bounce in May. Meanwhile, the unemployment rate surged to a four-year high of 5.7 percent as non-farm payrolls plummeted for the seventh consecutive month by 51,000 workers. In the housing sector, new and previously-owned home sales continue to contract, while the most recent S&P/Case-Shiller home price index fell by 15.78 percent in May from a year ago, marking the sharpest drop on record. Manufacturers have fared somewhat better thanks to export demand, though conditions are far from resilient. In fact, the July ISM index for the sector fell to 50 from 50.2, signaling that business activity stagnated.

Clearly, the most up-to-date data shows that the US economy is floundering. So will the FOMC move to cut rates anytime soon? Don’t count on it. Currently, fed fund futures are pricing in no change in rates on Tuesday, and a slight 8 percent chance of a 25bp hike to 2.25 percent (rate expectations are measured in the table below). Looking further ahead, though, overnight index swaps are currently pricing in approximately 75bps of rate increases within the next year. Why? Inflation fears. The Federal Reserve has many goals cited in its Mission Statement, with the primary ones being to conduct “the nation's monetary policy…in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” Now that the FOMC is dealing with two opposing factors – rising unemployment and accelerating price growth – their decision is far more complicated. With headline CPI jumping to 5.0 percent annual pace in June – a 17-year high – and core CPI rising to a 2.4 percent annual pace, the markets are betting that the FOMC is more likely to hike interest rates in an effort to make it clear that inflation is their primary concern.

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Watch What They Say, Not What They Do…

Though the FOMC is widely expected to leave rates unchanged at 2.00 percent this will still be an event worth watching since the Committee’s policy statement can be just as market-moving. One key thing to watch is the vote count: Dallas Fed President Richard Fisher was the sole dissenter in favor of a rate increase last time around, and if any other FOMC members join this list (such as Philadelphia Fed President Charles Plosser), this will likely lead traders to price in more aggressive rate increases in coming months. Likewise, notations of “high uncertainty” regarding upside inflation risks or the “elevated state” of inflation expectations” will also lead speculation of increasing rates and thus, a US dollar rally. On the other hand, the removal of the phrase noting higher inflation expectations or any reference to re-emerging downside risks to growth should lead the markets to price in a more neutral policy stance for the rest of the year. In fact, with expectations for rates in the US so heavily skewed to the upside, any tapering of this sentiment would lead the US dollar sharply lower.


Written by Terri Belkas, Currency Strategist and Antonio Sousa, Chief Strategist of DailyFX.com

Questions? Comments? E-mail: tbelkas@dailyfx.com or asousa@dailyfx.com



 

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