Dollar Treads Water ahead of Fed Rate Decision as Markets Look for Direction from Powell

© The White House

- USD steady ahead of landmark Fed interest rate decision.

- Analysts overwhelmingly look for 0.25% cut to Fed Funds rate. 

- But some still hold out for larger move, risking upward USD bias.

- June dot-plot and economic data risk steady rates, market upset.

- Analysts see USD retaining 'carry' crown and a bid regardless.

The Dollar was treading water early in the Wednesday session ahead of the July interest rate decision of the Federal Reserve (Fed), which promises to be a landmark moment in the 2019 story of the U.S. currency regardless of whether policymakers indulge markets with the rate cut they're anticipating. 

Analysts are overwhelmingly looking for the Fed to cut its interest rate by 25 basis points to 2.25% before following following up with two more equivalent moves later this year, which would take the U.S. benchmark of borrowing costs back to 1.75%, the same level it was at in March 2018.

However, some analysts and investors are still looking for the Fed to go further than that with a 50 basis point rate cut. The Fed's decision will have significant implications for the Dollar given the weight of expectations and the impact it will have on the attractiveness of U.S. bonds to investors.

If the Fed over-delivers against market expectations when the decision is announced at 19:00 on Wednesday then the beleaguered Pound-to-Dollar rate could rise as a result, but the increasingly Brexit-stricken Pound Sterling will suffer if financial markets are left disappointed by the bank's actions, or lack of.

"In part because we expect the pound to slide down to 1.05-1.10 and drag the euro along, we see the dollar recovering nicely from the Fed today, no matter what the Fed does or says. It would take a trade deal with China to change that outlook, and China is not about to swallow its pride for a deal. So we have the strange situation of rate cuts not driving a currency down when conventional wisdom says they should," says Barbara Rockefeller at RTS Forex.

Above: Market-implied probabilities of a 0.5% (left) and 0.25% rate cut. Source: CME FedWatch Tool.

"Wednesday's FOMC is likely to be the event of the month, if not the quarter, for the USD," says Greg Anderson, head of FX strategy at BMO Capital Markets. "With money markets pricing in a few bps more than one 25bp rate cut, we could see a USD rally if the Fed 'only' cuts by 25 and doesn't offer other dovish 'enhancements'. We would see a substantial USD selloff if the Fed cuts its base rate corridor by 50bps." 

Speculation about rate cuts has not been discouraged by the Fed itself either. Chairman Jerome Powell has said repeatedly that the bank will "act as appropriate to sustain the expansion", referring to the economy, while others have flagged weakening inflation pressures as a cause for concern. 

James Bullard, who's one of the most 'dovish' voters on the rate-setting Federal-Open-Market-Committee (FOMC), said in June that a "downward adjustment" to the cash rate might be required soon to help lift inflation back to the 2% target. The personal consumption expenditures price index, which is the Fed's preferred measure of inflation, rose 10 basis points to only 1.6% in June while the official consumer price index dipped from 1.8% to 1.6% that month too. 

Changes in rates are normally only made in response to movements in inflation, which is sensitive to growth, but impact currencies because of the push and pull influence they have over capital flows. Those flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. 

"A 25bp rate cut is fully priced in and is still not going to really satisfy anyone. Some market participants are already expecting a 50bp rate cut today and might initially trade the dollar stronger in their disappointment," says Esther Reichelt, an analyst at Commerzbank

Above: Dollar Index shown at daily intervals. Annotated for recent events. Click chart for larger version.

"With a 25bp cut well priced, the likelihood of any wild swings in the FX and rates markets is small. A 50bp cut would provide reason for bigger swings but we see little chance of that. With the likes of James Bullard, a well-known dove arguing for 25bps, we see a very high bar for a more aggressive cut," says Lee Hardman at MUFG.

Market expectations for rate cuts have mounted since May when an escalation of the trade war with China threatened to exacerbate an ongoing economic slowdown in growth elsewhere in the world, which could eventually clip the wings of the U.S. economy. 

These concerns have seen the financial community rapidly coalesce around the idea that the Fed, under fire from President Donald Trump for raising rates last year, will cut in order to provide itself "insurance" against a future slowdown. 

However, there's a number of recent developments that suggest Wednesday's decision is not quite the done deal markets assume it is, not least of all changes to the so-called 'dot-plot' of policymaker forecasts of interest rates back in June. 

Above: Pound-to-Dollar rate shown at daily intervals.

"While no other central bank in the G10 can compete with the Fed's policy rate cut runway, it could be some time before USD cracks sink the reserve currency. Even if the Fed eases by 75bps the market has already built the vast majority of this into the curve for this year. Even if delivered in full, the USD will remain the carry king among G10 currencies," says Mazen Issa at TD Securities.

Eight of the 17 voters on the FOMC still forecast in June that rates will remain unchanged for 2019, while another eight of them suggested they expect one interest rate cut before year-end. And one voting member still backed another rate hike for this year. Those dots make clear there was no majority for a cut back in June, which might be problematic for the market because the U.S. economic picture has actually improved since then, not deteriorated.

This means there might not have been enough of an increase in the number of policymakers who're willing to cut rates for a majority to be found in favour of the decision, which would be a significant positive for the Dollar.

"The dollar is unlikely to weaken this evening on the Fed’s rate cut but assuming guidance on further cuts is apparent and assuming Chairman Powell conveys caution over global downside risks, the scope for dollar strength should be limited," says MUFG's Hardman.

Above: Euro-to-Dollar rate shown at daily intervals.

U.S. GDP growth was 2.1% in the second-quarter, down from 3.1% in the opening quarter but ahead of the market consensus for a 1.8% expansion, according to data released last Friday. The beat resulted from consumer and government spending compensating for weakness elsewhere. 

This was after retail sales for the month of June surprised strongly on the upside the previous week. Official sales data showed U.S. consumer spending picking up sharply at the end of the second-quarter, even though global growth is widely expected to have slowed even further during the period.

In addition, and after the U.S. economy managed to create only a paltry number of new jobs in May, nonfarm payrolls growth rebounded strongly in June. The combination of the three reports has seen market concerns over the current health of the U.S. economy begin to appear exaggerated. 

Meanwhile, Fed Chairman Jerome Powell has frequently said that policymakers should not react to things that may well turn out to be temporary, which could have been a reference to either a 2019 fall in inflation or the May payrolls number. The comment could have also referred to both. 

"The impact of weakening economic growth globally is beginning to show up in economic activity in the US and the weakness could increasingly begin to impact equity market performance with a knock-on impact on consumer spending," Hardman warns.  


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