The Fed signals it’s ready to cut, but the dollar may not listen

The Fed chair has spoken to the US Congress, and he has been dovish. The market reaction is as one would expect – weaker dollar, higher Treasuries (lower yields) and a rousing stock market reaction. While lower US interest rates are likely to keep equities on top and bond yields lower, we aren’t so sure about its long-term impact on the dollar. 

Market could be too dovish 

Fed chair Jerome Powell told Congress that although the economy is likely to remain solid for some time, “uncertainties about the outlook have increased in recent months”, he also mentioned that “economic momentum appears to have slowed” in other economies that could impact the US. He cited the trade war with China, the federal debt ceiling, which could be breached as early as the first half of September, and Brexit as major risks to the US economy. He noted that weaker than expected inflation was also a risk, and that at its June meeting FOMC members discussed at length the benefits of cutting interest rates. While the Fed chair did not commit to a date when interest rates could be cut, or to the size of the cut, the markets have reacted. Those who follow our research closely know that we use the trusted CME Fedwatch tool to determine market expectations for US interest rates. After Friday’s super NFP number the market had practically priced out the prospect of a 50 bp cut at its meeting at the end of this month. However, after Powell’s testimony, the market seems to have forgotten the NFP number, and is now expecting a 20% chance of a 50-basis point rate cut on the 31st. 

Why insurance matters 

It is worth noting that the market has 0% chance of the Fed holding rates steady at this month’s meeting.  We agree with market consensus and expect the Fed to cut. However, based on chairman Powell’s testimony, we believe that this rate cut isn’t designed to boost a weakened US economy, instead a cut is more of an insurance policy against the risks and uncertainties that we mention above. This is an important distinction, and one that traders’ need to take note of for the following reasons: 

1, A 25 basis point cut is more likely in our opinion, however, a sizeable number think that the Fed could cut rates by 50 bps at this meeting. In our view that is way more than an insurance cut and is unlikely to happen. If the Fed does as we expect and only cuts by 25 bps, this could be considered a “disappointment” by the market leading to a fall in stocks and other risky assets, a rise in Treasury yields and a rise in the dollar later this month. 

2, Overall, we do not think that the dollar will be under a long-term threat from this rate cut because it is only an insurance cut, and not a reaction to a deteriorating US economy. Thus, any dollar weakness could be short-lived, and we expect the greenback to be one of the better performing G10 currencies this summer. A caveat to this would be deteriorating economic data that could trigger a rate-cutting cycle from the Fed later this year, which would likely be dollar negative, however, that is not on the cards at this stage. For now, however, we expect the Fed to adopt a one-and-done rate-cutting strategy, which should only lead to short-term dollar weakness. 

Why dollar weakness may not last 

The FX market’s reaction to today’s testimony from the Fed chair supports our view, after a sharp decline, the dollar is now starting to claw back earlier losses. For example, EUR/USD rose 40 points after the Powell testimony, however it is struggling around the 1.1250 mark, likewise, GBP/USD rose back above 1.25, however, it has since drifted back below this level. With Boris Johnson still the front-runner to be the next GB PM the pound is likely to struggle for the foreseeable future and could fall below the 1.2440 level in the coming weeks. GBP bulls are also likely to be disappointed that the better than expected industrial data and the pick-up in May’s GDP reading did not have a longer-lasting effect on the pound; political uncertainty around Brexit remains the key driver for sterling, and for now it’s more important than the economic data. 

Although USD/JPY took a tumble earlier today, the technical signals still suggest that momentum could be on the upside for this pair, and as long as it remains above 108.00, the bottom of its long-term range, then we have faith that the dollar could continue to climb higher. 

Why gold may lose its lustre 

In a scenario where the Fed is likely to cut interest rates then gold could be supported. It jumped back above $1,400 per ounce during the testimony, however it is experiencing some stickiness around $1,410. This is a key resistance level, and if the yellow metal cannot break above here, then gold bugs may share our view on the Fed rate cut: one cut only, before a period of stable rates, which could put a lid on the gold rally in the medium-term. 

Summertime shine on Greece 

Elsewhere, Greek bond yields fell below Treasury yields today. This is a momentous event, since at the peak of the Greek debt crisis Greek bond yields were 35 % above US yields. Investors have faith in Greek debt once more partly because of the election of the centre-right New Democracy party at the weekend, and also expectations that the ECB will re-start its bond-buying programme in the Autumn to the tune of EUR 50bn. With Eurozone economic data looking fairly shaky, and signs that the Eurozone earnings season could be weak, after a large earnings downgrade from BASF sent European equities tumbling on Tuesday, the outlook for the euro remains guarded, and any upside could be faded, especially vs. the USD. 

Why US stocks still impress  

The S&P 500 rose above the 3,000 level for the first time on the back of the Powell testimony on Wednesday, although at the time of writing it had backed away from this milestone. We believe that the longer-term outlook for the US indices will be determined by the US earnings season which shall soon begin in earnest for Q2. Even if the Fed only cuts by 25bp in a couple of weeks’ time, we believe that US stocks are well placed to outperform in the next month or so due to the relative out-performance of the US economy; although a stronger dollar could start to bite as we move into the Autumn months.