FX Update: Sterling in freefall on game of chicken

FOMC preview: Fed cutting has nothing to do with dual mandate?

It’s easy to scratch our heads and wonder why the Fed feels the need to start an easing cycle when asset markets are trading at record highs and the unemployment rate is near record lows. The Fed has ginned up the weak “symmetric inflation” argument to explain its motivations (the need to move inflation above the 2% target for some time to compensate for periods in which inflation was below that target). But the true source of the Fed’s moving to cut is that is has already largely lost control of policy. The lack of dollar liquidity provides its own dynamic and has been aggravated by Trump’s massive tax cuts and stimulus requiring the US private sector to soak up vast quantities of treasuries now that foreign buyers are no longer adding to reserve holdings. Another immediate factor is the debt ceiling suspension from the deal Trump made with Congress,  which will now see the US Treasury building its reserves again to the tune of hundreds of billions of USD.

As well, other central banks are already winning the race in a competitive devaluation game (“currency war”). And the fact in and of itself that the massive shift in the Fed’s policy outlook has failed to weaken the USD is providing its own motivation and forcing the Fed’s hand. Shortly put, everyone wants to know whether the Fed will cut 25 basis points or 50 basis points tomorrow, but I am not sure that it matters beyond the initial knee-jerk. To get ahead of the USD liquidity issues, the Fed will have to soon start QE and massively so – rate cuts area a mere distraction. 

Worst, the trading environment will likely prove tricky. We have made a long term weaker USD call in our Q3 outlook – but if the Fed proves too slow here, we could just see another spike higher first. That spike in turn will drive the next Fed policy move and so on, ad infinitum. And the Tweeter in Chief at some level in the USD will also be happy to break precedence (and recent direct denials) and empower the US Treasury to intervene in the market, although the first move may be via trade policy bullying.

This environment will require nimble trading and the use of options. And outside of sterling – volatilities look like a bargain for going against the grain and beginning to establish longer term USD shorts versus the JPY and EUR if the USD breaks higher here, even if trading tactically for short term USD strength.

What else is up this week?
The FOMC meeting tomorrow is clearly the main event this week for all markets, but we also have the US June PCE inflation data up today, expected at 1.5% YoY for the Core number. Consumer Confidence is up later today as well. Tonight, we have a Bank of Japan meeting (no move expected there), and an Australia CPI reading, which could further impact the Aussie’s profound recent slide – Australia’s 10-year yield has slide to new lows near 120 basis points – unprecedented levels.  

Tomorrow, ahead of the FOMC meeting, we have Germany employment change data and the EU’s first look at Q2 GDP and the flash Jul CPI, as well as US ADP payrolls for July. Thursday is world Manufacturing PMI day and the BoE meets (no interest rate move expected – reserving bullets for knowing what Brexit looks like). Finally, on Friday we get a look at the latest US payrolls and earnings data, as another  weak month begins to show the short term moving average for payrolls in decline (although weekly claims not confirming of late).

Upcoming Economic Calendar Highlights (all times GMT)

• 0900 – Euro Zone Jul. Confidence Surveys
• 1200 – Germany Jul. Flash CPI
• 1230 – US Jun. PCE Inflation
• 1300 – US May S&P/CoreLogic Home Price Index
• 1400 – US Jul. Consumer Confidence
• 0100 – New Zealand Jul. ANZ Business Confidence /Activity Outlook
• 0130 – Australia Q2 CPI
• Overnight: Bank of Japan Statement