The Federal Reserve Bank is widely expected to keep interest rates unchanged at 5.25% for the seventh-straight meeting. We expect the statement to be negative for the dollar, positive for equities and neutral-to-positive for short-term treasuries for the following reasons:
Although the Fed is likely to reiterate the ”predominant policy concern remains the risk that inflation will fail to moderate,” we expect it to acknowledge the recent softening in inflation, as measured by the March core PCE and core CPI figures, which should be dollar negative. The retreat in the March inflation figures data has been considerably evident to the extent that the Fed will have to modify the phrase indicating that: "Recent readings on core inflation have been somewhat elevated."
The Fed’s growth assessment should remain unchanged because the current phraseology allows for acknowledging further weakness in the economy without the need to alter this part of the statement. Thus, the FOMC is likely to maintain that:” the adjustment in the housing sector is ongoing” and “economy seems likely to continue to expand at a moderate pace over coming quarters.” Also note that the Fed has removed last year’s reference to the labor market, preferring not to trigger additional market volatility considering the recent weakening in the labor market.
With the recent U.S. data showing lower inflationary pressures, weaker employment growth and continued slowing in GDP growth, the Fed’s continued focus on inflation vigilance will be challenged by the markets. Indeed, the Fed’s ongoing focus on inflation vigilance was weakened by the March data showing core PCE price index slowing to 2.1% from 2.4%, and core CPI slowing to 2.5% from 2.8%, the lowest since May 2006. Employment payrolls slowed to the lowest pace in three years, while GDP growth showing at its lowest pace in four years.
An increase in the May unemployment rate (due in May) to 4.6% or 4.7% from the current 4.5% combined with additional retreat in CPI and PCE price index, should open the door for an August rate cut in the event that these indicators are accompanied by a further slowdown in housing retail sales and industrial production. The downside risk to the equity market is also a key factor in future easing action by the Fed. While we have not abandoned our calls for a June rate cut, we expect a 75% chance for a third-quarter rate cut to start as early as August.
In contrast, Thursday’s Bank of England (BoE) decision is widely expected to produce a 25-basis point rate hike to 5.50%, while the European Central Bank (ECB) is expected to open the door for a June rate hike to 4.0%. These developments are expected to prolong the euro’s bullish run, whose sustainability has rested on periodic retreats—an effective means of avoiding rumblings from European politicians.
Euro to regains upward momentum Thursday’s ECB decision is expected to maintain rates unchanged at 4.0%, keeping the door open for further rate hikes starting in June. Recall the April press conference did not specify that the ECB was vigilant on inflation, possibly to indicate no change in May, but it will likely express inflation vigilance to allow for the possibility for a rate hike in June. We expect the ECB to make two 25-bp rate hikes to 4.25%. Note that the ECB is comfortable with a strengthening euro to the extent that it helps combat inflation, as long as it poses no challenges for exporters.
Now that market-friendly candidate Nicolas Sarkozy has won Sunday’s French presidential election by a convincing margin, we expect the EUR/USD to regain its upward momentum towards the 1.3630 target, followed by 1.2650. Support seen climbing to 1.3580. Key foundation stands at 1.3560.
Sterling to regain $2.00
Our bullish assessment for sterling this week rests on the widely expected Bank of England rate hike this Thursday. This will raise UK rates to 5.50%, placing them above U.S. rates for the first time in 16-months. Sterling is especially expected to benefit from the Fed’s expected acknowledgement of prolonged weakness in U.S. housing and labor markets as well as the softening in inflationary pressures. With the possibility of an additional BoE rate hike later this year after this week standing above 50%, sterling should remain supported towards 1.9980 and 2.0010. The only source of downside risk we see is in the event that the Fed does not acknowledge the recent deterioration in U.S. data and the softening inflation. Support stands at 1.9925, followed by 1.9890.
USD/JPY to extend pullback
Although the prolonged reduction in risk appetite and equity market has helped fuel the dollar/yen rate, we expect the Fed factor to weigh on the greenback as traders further remove dollar longs generated throughout the prior week. Today’s release of the minutes from the last Bank of Japan policy board meeting gave little in the way of new information as the policy board communicated the need to maintain current rates for some time. We expect the dollar part of the USD/JPY rate to resurface as expectations of a Fed easing draw near.
Our support projections lie at 119.70, followed by 119.50. We expect further declines towards the 100-day MA of 119.20 later this week. Upside capped at 120.20. Key resistance at 120.45.
Ashraf Laidi
Chief FX AnalystCMC Markets US 140 Broadway, 30th Floor New York, NY (212) 644-4220a.laidi@cmcmarkets.com
