Considering the recent data weakness and cooling inflation, it may well be a "slam dunk" that the Federal Reserve Bank will make a move towards more dovishness in today's Federal Open Market Committee statement.
We expect the Fed to make subtle changes to the characterization of core inflation without necessarily altering its growth assessment.
On the growth front, the Fed is likely to stick with the growth downgrade already made in the March statement, which removed the phrase “somewhat firmer economic growth” and replacing it with “mixed.” The last statement also downgraded its housing market assessment by replacing “tentative signs of stabilization in the housing market” with “adjustment in the housing sector is on going.”
On the inflation front, the Fed may make another subtle change to its core inflation characterization after downgrading it to “somewhat elevated” and “improved modestly” in the March and January statements respectively, from “elevated” in each of the meetings of the tightening campaign starting in June 2004. But we also expect the Fed to maintain that its “predominant policy concern remains the risk that inflation will fail to moderate as expected,” because a removal of this phrase would have negative implications this may bring about to the dollar and bond yields.
Although the March economic data have shown a softening in growth and core inflation, the Fed may not be able to afford recognizing both dynamics as this would accelerate the sell-off in the dollar, which in turn may become inflationary in the medium term.
In the event that the Fed makes minor changes to its characterization of core inflation without altering its predominant policy concern, the dollar could push higher on the rationale that the Fed is content with the policy at status quo.
We continue to expect a 70% to 75% chance of a rate cut in June based on our expectations for a renewed sell-off in equities that will act as a catalyst to drying liquidity and exacerbating the ongoing slowdown in housing and consumer demand.
Euro is seen regaining 1.36 after Fed We expect the euro to regain the 1.36 figure because the Fed has no choice but to make at least one downgrade in its balance of risks. Said differently, the Fed has no reason to lift its assessment on growth and inflation. We expect the euro to remain capped near the 1.36 figure ahead of Thursday’s European Central Bank (ECB) decision. Support stands at 1.35, followed by 1.3470—the three-month trendline support.
USD/JPY risks remain to downside We continue to see the ongoing support in USD/JPY because of falling risk appetite and rallying global equities rather than a reflection of improved USD fundamentals. Our expectation for a slight downgrade in the Fed’s assessment for inflation and growth is expected to be dollar negative. We expect USD/JPY to extend its gradual pullback towards 119.45 as the technical backdrop in the pair suggests further correction. Interim support stands at the 100-day moving average of 119.20. A rebound towards 119.70, is seen capped at 120.
Cable's gains capped at $1.9970 With the Fed expected to make a downgrade in either inflation or growth and the Bank of England (BoE) widely seen raising rates by 25-bps tomorrow, sterling’s upside has yet to be revisited. Thursday’s BoE rate will lift UK rates 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 above 1.9750, eyeing 1.9980 and 2.0010.
The main source of downside risk we envisage is in the event that the Fed does not acknowledge the recent deterioration in U.S. data and the softening inflation. The other source of sterling risk would be a sell-off resulting from disappointment that the BoE did not deliver 50-bps. Support stands at 1.9850, followed by 1.9795.
Ashraf Laidi Chief FX Analyst CMC Markets US 140 Broadway, 30th Floor New York, NY 10005 (212) 644-4220a.laidi@cmcmarkets.com
