It was a quiet session in markets yesterday ahead of today’s key Federal Reserve interest rate decision. The Pound continued to recover ground following Friday’s slide as reports suggested Prime Minister Theresa May remains supported by her Cabinet. However, GBP/USD continues to trade over one basis point below last week’s high, illustrating the significance of the deterioration of EU-UK relationships at the Salzburg summit. The Euro remained firm against the Dollar, despite the European Central Bank’s (ECB) Chief Economist playing down President Mario Draghi’s hawkish comments on Monday. Peter Praet referred to Draghi’s concerns about a ‘vigorous’ pick-up in inflation as not ‘anything new’. He recognised that wage growth is still ‘moderate’ and noted risks to inflation because of a potential ‘growth accident’. This supports our underweight view on the EUR as discussed in yesterday’s analysis.
The main event today, is of course, the Federal Reserve September interest rate decision. As the global pacemaker of loans and credit, its policy decision will have implications not just for the US, but for the world, and in particular emerging markets.
Financial markets bets are stacked for further rate rises from the Fed. In currency markets, Dollar holdings are at their highest level since May 2017. In the bond market, short holdings of 10-Year US Treasuries are approaching a historical high – a bond market bet for continued Federal Reserve rate rises. Financial markets are pricing in a 100% probability of a rate hike at today’s meeting. It’s clear where the pain for USD lies; with bets this stacked for the Federal Reserve to continue raising rates, the risk is that the Fed disappoints, and the Dollar promptly slides.
There are four key things to watch in today’s Fed meeting. First, the rate rise itself. The Fed raising rates to 2.0%-2.25% is almost guaranteed. Second is the ‘dot plot’ or the Fed projection of where the interest rate will be for the next three years. With a rate increase almost guaranteed in September, the main question is the interest rate path beyond 2018. Any downgrade in the Fed’s future forecast for the rate would cause the Dollar to tumble.
The third aspect to watch is the word ‘accommodative’. After seven increases in the US interest rate, it is fast approaching the neutral rate – the interest rate at which the economy will continue to add jobs without stoking excessive price growth. A debate has emerged among Fed officials about the interest rate still being described as accommodative when it is so close to the neutral rate. If the Fed continues to describe the interest rate as accommodative, it suggests the US economy needs a higher interest rate to keep from overheating. This would be perceived as hawkish and would cause the Dollar to strengthen at the margin.
The final aspect to note is the Fed’s forecasts for economic growth and inflation. A 10% tariff on USD200bn of Chinese imports and retaliatory tariffs from the Chinese took effect this Monday. The new projections will incorporate this. While it could result in a reduction of US growth and increase inflation, its magnitude is only likely to be in the order of a few tenths of a percentage point.
The US economy’s performance has been faultless recently, so would the Fed possibly suggest less rate hikes to come? The more the Fed raises rates, the more the Dollar rises and import prices fall, meaning US inflation might not accelerate as much as expected. US growth has been supported by President Trump’s tax cuts and spending increases. This short-term boost won’t last and risks a US slowdown in 2019. Thirdly, the more the Fed raises the interest rate, the more it equalises rates across lending durations. This phenomenon, called yield curve inversion, has predicted every recession for the last 50 years. The last time the Fed ignored this, the 2008 financial crisis happened. While we can’t fault the US’s current growth scorecard, expectations are high setting the Dollar up to disappoint.