The dollar pares gains and stocks push higher as the Federal Open Market Committee (FOMC) decision reveals that Dallas Fed President Richard Fisher was the only dissenter against the FOMC decision to hold rates unchanged at 2.00%. The fact that Philadelphia Fed President Charles Plosser did not vote for a rate hike, despite the onslaught of his hawkish rhetoric over the past few weeks, reflects his decision to await any dampening impact on inflation from the sharp retreat in commodities prices. It may also be a reflection that Plosser’s district of Philadelphia, a highly industrial area in Pennsylvania and Western New Jersey, which is sustaining increasing economic headwinds and an erosion in jobs, as is signaled in the Philadelphia Fed survey.
Reduced odds of a Fed tightening are weighing on the dollar while allowing stocks to rally on the notion that the Fed will not risk derailing the economy and financial markets via monetary discipline.
The Fed did make a subtle downgrade of economic conditions by saying:” Although downside risks to growth remain…,” and omitting “...they appear to have diminished somewhat.”
We consider today’s policy announcement to be a modest step back towards a neutral policy stance, which will be further extended during the inter-meeting period through speeches and pronouncements as inflationary pressures begin to show signs of a peak. The combination of prolonged demand destruction in and outside of the United States is likely to dampen oil prices back towards the $110 to $105 territory, thus allowing policy makers wider scope to for worrying about stimulating stalled economic growth. This is especially highlighted by the dissipating impact of the stimulus package on consumer demand.
Recall that immediately after the June 25 decision odds of an August hike stood as high as 30%, while odds for a September rate hike stood as high as 65%. Both of those probabilities have dropped sharply over the past five weeks, showing that fed funds futures serve more as a coincident gauge of Fed policy rather than a reliable forward looking indicator. We expect that odds for any tightening will recede further to the point of pricing chances for renewed easing. We stick to our forecast of 50 basis point easing by year end.
Further scaling down in the odds of a Fed tightening may not be necessarily dollar negative due to the early stages of economic weakness in Euro zone, UK, Canada and Australia. Nonetheless, an early stage of a slowdown in those regions does not imply a deeper contraction than in the United States. We expect EUR/USD to remain supported at $1.5450, backed by $1.5415 and $1.5350. Thursday’s European Central Bank press conference is likely to provide the usual support for the euro. Yen crosses are nudging higher as stocks cheer the market’s interpretation of reduced expectations for Fed tightening. The outcome is good for risk appetite at the expense of the Japanese currency, but USD/JPY once again is seen caped at 108.40.
