What’s next for the Fed?


When the FOMC decided to leave rates on hold earlier this month, Yellen cited slowing growth in the first quarter of 2017 as “transitionary” leaving the market with the belief that tighter policy will be forthcoming in the months ahead amid “solid” job gains and continued growth in consumer spending. The median forecast of Fed officials was for an additional two quarter point hikes this year and the markets increased the odds of a June hike from 70% to 90%.

 

After May’s payroll figures (see chart below) showed a stronger than expected +211k increase in April  exceeding the consensus forecast for a gain of +185k and suggesting that the previous months’ reading of a downwardly revised 79k was just a blip in what has otherwise been a gradually improving trend, the futures market now has a hike next month as a certainty. Despite this, the dollar has continued to remain under pressure, most notably against the euro, but also on a broader trade weighted basis.

 

Picture1

 

CHART 1 – US Non-Farm Payrolls 2012 – 2017

 

 

We see three key reasons for this:

 

Firstly, there is growing uncertainty about Trump’s ability to implement many of the policies and reforms that won him the election last year. Trump now has the widest credibility gap since Richard Nixon during the Watergate scandal and his recent controversies have taken their toll on America’s view of Trump. In a recent Quinnipiac Poll earlier this month, 61% – 33% of those surveyed said that Trump isn’t honest. The 28% gap is double the score in the same survey at the beginning of the year. It is also worth noting that the poll was taken before Trump’s decision to fire FBI Director, James Corney, so if re-run, the gap would most likely be even wider.

 

Secondly, while the markets are pricing in a 100% probability of a Fed hike next month, there is growing uncertainty about what comes after that. Yellen has signalled another hike before year end, but the markets are yet to be convinced. As highlighted previously, the Fed has a history of failing to deliver on expectations of tighter policy (most recently in 2016). The swap curve is still relatively flat beyond two years and longer term remains inverted signalling an expectation that higher rates are unlikely to be sustainable.  As such, the risk of the Fed being less hawkish than the market is currently anticipating is greater than the risk of the Fed exceeding expectations in terms of monetary tightening.

 

The third factor, is less to do with the dollar itself and more about the indirect impact of improving sentiment elsewhere. The euro has made steady gains following the French election and a general improvement in the economic outlook. While we still envisage plenty of problems for the single currency going forward, short term momentum suggests that the majority of market participants are happy to ignore those for now. 

 

What does all this mean for the dollar?

 

In the short term, momentum has shifted against the dollar which suggests further downside risk. EUR/USD has sustained a move through the 1.08/1.10 resistance zone and now looks set to test the top of the long-standing range (dating back to January 2017 – see chart 2 below) before additional resistance is likely to be encountered at 1.1500. Meanwhile, GBP/USD has broken through the psychological 1.30 level and while it doesn’t seem to be motoring on with the same vigour, a test of the September 2016 high at 1.3445 looks within the realms of possibility in the coming weeks.

 

Capture

CHART 2: EUR/USD 2015 – 2017 range

 

For our North American friends with CAD exposures, the recent USD weakness has slowed the recent advance in USDCAD. However, at this stage, we see no reason to change our bearish stance on the CAD and we continue to expect this to result in a test towards 1.40 again later this year.  

 

Author: Marc Cogliatti



 

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