US Dollar is a 'Buy' if Fed Provides a Green Light after Wednesday's FOMC Meeting

- USD/JPY an attractive long given central bank divergence.

- Traders could be waiting for go ahead from today's meeting.

- Economists are split but sizeable portion see growth, USD peaking.

© Dmytro Synelnychenko, Adobe Stock

For the Dollar, not much volatility is expected from Wednesday's Federal Reserve meeting (Fed) as the US central bank is not expected to raise interest rates so soon and received wisdom says it would take another rate rise or similarly bold move to push the greenback higher.

There is no press conference with Chairman Powell or new forecasts to be released at this meeting, which further diminishes the possibility of movement in FX markets. Yet one view has it that solid fundamentals and a surprisingly dovish Bank of Japan (BOJ) are likely to keep demand for the Dollar high, especially versus JPY, which could see a bid following the meeting.

Such is the opinion of FX veteran Kathy Lien, co-director of BK Asset Management, who says that rather than being a damp squib today's meeting could prompt some surprising moves in the markets.

"Having just raised interest rates in June, we know that the Fed won’t be making any changes this month. So the big question is whether the dollar will have any reaction to FOMC – and we think it will," says Lien.

Lien cites several reasons for this left-of-field-view. The first is trader demand for Dollars relative to the Yen after the BOJ disappointed markets with a dovish policy announcement on Tuesday morning. Although the BOJ made a tweak to monetary policy the change was so negligible as to barely register, and the bottom line was things arn't going to change.

The BOJ ostensibly relinquished some control of the yield curve, saying, long-term yields would be allowed to "move upward and downward depending on economic and price developments,” but, according to analysts such as Lien, they, nevertheless, intend to keep yields near zero as they did previously when they targeted the long end of the curve.

If the BOJ had been bolder and lifted the negative deposit rate, as some analysts had speculated, in order to help struggling commercial banks then the Yen would have shot higher but as it was they kept policy unchanged.

Hopes were dashed the BOJ might be emerging from decades of abnormally low rates and as a result the Yen started to slide against the Dollar again. This policy standstill widened "the gap between Fed, BoE and ECB policies," says Lien.

The upshot for traders is that a dovish BOJ gave a green light to Dollar bulls, who may be waiting for the Fed meeting to confirm the go ahead, before jumping back into long positions. Lien says US fundamentals are top draw so Wednesday's meeting might provide the green light traders are looking for.

Above: USD/JPY chart at daily intervals.

"The Fed will tell us that further tightening is needed because the labor market is strong and economic activity is growing at a solid rate. Inflation is on the rise, manufacturing and service-sector activity is accelerating while spare capacity is declining so there’s no reason to deviate from their plan to tighten again," says Lien.

One focus of the market at tonight's FOMC will be whether the odds of a September rate hike remain at their current, elevated, 80% probability levels. Lien thinks they will as economic conditions hare not changed much since the June meeting.

Although labour market conditions worsened slightly, job growth remained strong. Retail sales increased and inflation is on the rise, but housing activity weakened. Both the manufacturing and service sectors reported stronger growth, personal income and spending growth are healthy and manufacturing activity in the Chicago region accelerated significantly.

"So the FOMC statement will most likely highlight the underlying strength of the economy and the uptick in inflation," says Lien.

Above: BK Asset Management graph showing US data outcomes vs expectations.

The clean bill of health will probably boost the Dollar as it will keep hopes alive that the Bank will raise rates both in September and then again in December. 

This will probably lead to even wider divergence between US and Japanese monetary policy expectations, "and should be enough to take USD/JPY above 112," says Lien. USD/JPY has actually already risen above 112 at the time of writing.

How to Trade it?

There is unlikely to be any material changes to the FOMC statement in June and USD/JPY could dip initially, however, this is probably just a temporary pull-back and would be a signal to buy. Yet, if there are hawkish tweaks to the statement, USD/JPY becomes a great buy according to Lien.

Alternatively, if the Fed raises fresh concerns no matter how large or small, as there may be given the announcement of more tariffs this morning, "the best currency pairs to trade are USD/CHF to the short side or USD/CAD and AUD/USD to the long side," concludes Lien.

Concerns have already been raised by analysts for some time that the current strong growth in the US is an artificially manufactured "sugar high" which won't last, and this has led to several big name banks calling a top in the Dollar.

"There's a growing chorus singing that the U.S. dollar rally is just about finished. State Street joined Morgan Stanley and Wells Fargo in saying the greenback is nearing its peak after gaining around 5 percent since mid-April. Currency jawboning by Trump, shifting growth expectations outside America, and tweaks to central-bank policies could help drive it lower," says Bloomberg News.

A more optimistic view, however, recently came from the influential financier Mohamed A. El-Erian, chief economic adviser at Allianz SE and former CEO of the world's largest bond investor Pacific Investment Management Company (PIMCO), who said the US was unilaterally exiting the 'new normal' era of low interest rates, low inflation and weak growth, and that it is 'in a league of its own' as far as growth is concerned.

He added that fiscal stimulus in the US would enable the central bank to raise interest rates back up to normal levels, from where the bank could lower them again in the future if such a move is required. His comments suggested Dollar strength will endure.

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