Will the Fed spook dollar bulls?

The main event this Wednesday is the FOMC meeting later this evening. This will be the first Fed meeting since March, when FOMC members shifted to a neutral stance and suggested that they would press pause on hiking interest rates. The question now is, will they continue to emphasise this message, or will fresh record highs in US stock markets, coupled with strong GDP growth for the first quarter cause the Fed to be less cautious this time? 

The Fed vs. the market, who is right? 

There is an interesting dynamic going on in financial markets right now. The market is currently pricing in a 66% chance of a rate cut by the end of this year, based on the Fed’s dovish tilt at its last meeting. However, the Fed’s dot plot, also released at the March meeting, showed that no FOMC member is expecting a rate cut this year. So, who is going to be right? Those of a more cynical nature may say that the Fed has a tendency to do what the markets want, which appears to be a rate cut. However, if you dig below the surface of some of the strong US economics reports then you may find that the market is right about its assessment for the trajectory for US interest rates. Although the headline GDP report was stunning, with a 3.2% annual rate of growth in the first quarter, the driving forces of growth were transitory, including a large inventory build-up and external trade growth, which tends to have a one-off effect on the economy. Of more concern is the weakness in inflation, with the Fed’s preferred measure of inflation, the core Personal Consumption Expenditure inflation index coming in at 1.6% for March, which was weaker than expected, and below the Fed’s target rate of 2%. Thus, based on the fundamentals, the Fed could justify shifting its Dot Plot inline with market expectations. 

Is the dollar at risk? 

Adding another dimension to today’s FOMC meeting is the market reaction since March. US stock markets are at record highs, which is not unexpected when the market thinks that looser monetary policy could be on the cards, however the dollar index has also rallied to a two-year high. Usually the buck is closely linked to rate expectations, however, recent dollar strength suggests to us that even if the market believes that the Fed is seriously considering a rate cut in 2019, its monetary policy stance is likely to remain tighter than other major central banks including the ECB, BOE and the BOJ for the foreseeable future. 

What to expect from the FOMC 

While we don’t expect any major shift in monetary policy stance from the Fed, tonight’s meeting and press conference is likely to give us an update about the Fed’s view of the US economy. We expect them to say that growth remains strong, however, they should also sound a warning note about the weak level of inflation in the US economy, which justifies a neutral to lose stance in policy. The Dot Plot is the crucial part of this evening’s release. If there are any shifts in FOMC members’ expectations for interest rates then we may see a sharp repricing of asset prices, particularly the dollar. We believe the   risk is larger that a member shifts to a more dovish stance at this meeting, and if the Dot Plot suggests that members of the FOMC are expecting a rate cut this year, in line with market expectations, then we would expect sharp and broad-based declines for the dollar. 

The dollar outlook 

We have seen some dollar weakness as we lead up to this meeting, especially against the pound, which is back above $1.30 at the time of writing. A dovish Fed could see this pair gain further traction to the upside, with $1.31 then $1.3150, the high from early April,  coming back into view. The reaction in US stock markets is also worth noting. After reaching fresh record highs on Tuesday, we think that a further dovish tilt from the Fed, particularly if it is driven by fears for the strength of the US economy, may trigger a bout of profit taking and weakness for US and global equity markets in the aftermath of today’s meeting. 

Why is the pound rallying? 

The pound’s strength this week has been interesting. There have been no Brexit developments recently, so sterling’s strength may be a delayed reaction to the long Brexit extension until October. The pound has been under pressure for nearly three years at this stage, thus it may also have a long, slow recovery that takes place over a number of months or even years. Although we may have turned a corner for GBP/USD, and a return to $1.40 is potentially on the cards, achieving this level could take time and the pound may not move forward in a straight line. It is worth noting that most of Europe is out for a labour day holiday on Wednesday, thus EUR/GBP could be less liquid than normal. 

FTSE 100 vs. FTSE 250, who will win out? 

The inverse link between the pound and the FTSE 100 has re-established itself yet again, as the pound strengthens on the back of a reduction in Brexit fears, the FTSE 100 is back under pressure. A better reflection of the stock market’s reaction to the Brexit delay is the FTSE 250’s performance. The broader index of medium-sized UK companies has outperformed the FTSE 100, as investors’ choose domestic-focussed stocks above international focussed ones. Today’s FOMC meeting could impact the relative performance of the FTSE 100 and the FTSE 250. If the Fed sounds concerned about US demand, then we would expect the blue chip global indices, including the FTSE 100, to underperform the domestic-focussed indices like the FTSE 250. 

Elsewhere…

This week’s market excitement does not end with the FOMC meeting, we also have the US’s NFP report on Friday. Watch out for our bonus note to get our view on what to expect from Friday’s payrolls report. European PMI’s, the BOE meeting, UK PMIs and the US ISM reports are all due before the week comes to a close, so the data deluge could determine the near-term direction for markets.