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Forex: FOMC Outlook– Judgment Day For the Dollar

DailyFX Fundamentals 05-02-05

By Kathy Lien, Chief Strategist of www.dailyfx.com

· FOMC Outlook– Judgment Day For the Dollar
· Eurozone Weakens As Manufacturing Sector Contracts For First Time Since August 2003
· Chinese Revaluation Talk Will Continue To Drive Yen Despite Golden Week Holidays

US Dollar

The US dollar is extending last week’s rally as we close in on tomorrow’s FOMC rate decision. We have been combing the various bank research reports that we have access to and we see one very interesting and clear trend, which is that bank analysts across the board have been pretty hush about their views in their weekly reports for this upcoming meeting. Most economists instead have chosen to focus on Chinese revaluation, which is important in its own right, but not urgent enough that it warrants so much coverage that projections for the Fed meeting should completely be ignored. Usually by now, we are accustomed to a barrage of FOMC outlook reports with strong views about what the Fed may do. This time around though, the murkiness and simply lack of commentary only indicates one thing – that is there isn’t a consensus view on the Fed’s actions. There is no doubt that the Federal Reserve will be granting the markets another quarter point rate hike, but the Fed’s words and not their amount of tightening will be the main focus. Given that recent economic data has been mixed, the market’s expectations are definitely tilted to the downside. According to David Altig, one of our favorite economists, expectations for tightening have changed since Friday’s economic releases. Prior to Friday’s data, options for Fed Fund futures had predicted 100bp of tightening over the next 4 FOMC meetings. Following Friday’s data releases, expectations have shifted to a possible pause in either August or September. Fed watcher John Berry of Bloomberg is also calling for a retention of the phrase “measured.” The Fed knows that the removal of the phrase would be perceived as the Fed taking a more aggressive stance on policy, which current circumstances do not necessary warrant. If the Fed leaves their statement unchanged, the dollar should have a slightly bearish to neutral reaction while the removal of the phrase would be a bullish signal for the dollar. Meanwhile it should not surprise us that today’s US economic data was also mixed, with manufacturing sector ISM falling short of expectations and construction spending rising by more than expected.

Euro

Weak economic data continues to weigh on the Euro, though the single currency will probably continue being the dollar’s puppet over the next 24 hours as US economic data and events overshadow developments in the Eurozone. According to the Purchasing Managers Index, the manufacturing sector contracted for the first time since August 2003, dragged lower by deteriorating conditions in France. On a country-by-country bass, the PMI index for both Germany and France dipped below 50 in the month of April, with across the board declines in the orders, output and employment indices. The only story breeding in the Eurozone continues to be the French polls for the EU constitution. In a shift in the direction of sentiment, two new opinion polls indicated that the no votes were losing ground. In fact, one of the polls even suggested that the yes camp has taken the lead with 52% of those polled by TNS-Sofres supporting the Constitution while 28% opposed it. Though this report is certainly encouraging, there is no doubt that the opposition still holds the lead according to other polls.

British Pound

With the UK markets closed for a bank holiday, traders sent the British pound tumbling on thin trading. The sharp decline could be mostly attributed to the liquidation of carry trades ahead of tomorrow’s FOMC rate decision. With the expected quarter point rate hike from the US, the yield advantage that the pound offers over the dollar will shrink from 200bp to 175bp. Over this past year, the GBPUSD has been particularly sensitive to developments that threaten the pair’s high-yielding status. Historically, the GBPUSD has been a very popular carry trade due to its high interest rate and liquid financial markets. This week, the most important event on the UK calendar is the election on May 5th. Although Prime Minister is widely expected to win another term, the election is still tight with both parties zeroing in on the 100 marginal constituencies.

Japanese Yen

The dollar managed to recuperate marginally after its strong sell-off on Friday. Economic data released last night was mixed, with a stronger employment and auto sales report but a weaker labor cash earnings report. Japanese markets are closed tonight for a national holiday. Most Japanese traders are out of the office this week due to the Golden Week holidays. However, this doesn’t mean that trading in USDJPY will grind to a halt, especially since speculation of Chinese revaluation and not Japanese fundamentals have been the primary driver of the yen over the past few days. Confirming our long-held belief that the Japanese yen would be the most sensitive currency to revaluation developments was the price action in the yen minutes after the supposed technical glitch that allowed the yuan to break out of its prescribed trading range during Asian trading on Friday. The Japanese yen was the first to react, followed by the euro and then the Australian dollar. It is also hard for us to believe that this is a technical glitch or a slip by the People’s Bank of China, especially since it comes the same day that a front-page article appeared in a Chinese state run paper saying that conditions are “ripe” for changes to the Yuan’s exchange rate. More likely, the Chinese government was probably testing the markets ability to manage a minor fluctuation in the Yuan although they denied doing so. What we do for sure though is that we are getting closer and closer to revaluation and as such, traders should be prepared for it. The announcement will probably be one of those things that will cause a sharp immediate movement in the market, which makes the employment of stops, especially overnight stops even more important.

 

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