FX Update: Final thoughts ahead of FOMC

FOMC last thoughts

The consensus view for tonight’s FOMC is that the Fed cuts 25 basis points and can point to recent weak inflation numbers – especially the June PCE inflation miss this week – in shifting to a bias for further cautious cuts to achieve its “symmetric” inflation target. There are no new projections and dot plot forecasts for this meeting – the next batch of these arrive with the September FOMC meeting. As we discuss below, however, there are a number of other moving parts that will deserve the market’s attention over this meeting and deserve more focus than the expected quarter-point cut. 

A few FOMC wildcards to consider: 

Early end to QT – We have discussed that USD liquidity issues Fed challenges in maintaining effective implementation of its policy rate, strongly affected by the US running large deficits and now aggravated by the need for the US Treasury to build reserves are more important factors occupying the Fed’s attention than the need to reduce the policy rate. In that light, the hot button issue is the wind-down of the Fed’s quantitative tightening, which it could possibly end early. The market may take this as a sign that the Fed understands that balance sheet moves are more important than interest rates adjustments. A move now to halt QT would be a dovish surprise (hard to know the odds – but its quite possible).

Standing repo facility – we are expecting the Fed to shift towards the standing repo facility at some point, which is would allow the Fed  to maintain more direct control over its policy rate in the US financial system, after signs starting last year that it was having difficulty controlling the actual Fed funds rate and prompting the move to cut the IOER slightly even as the main policy rate was unchanged earlier this year. If this is seen a significantly easing USD liquidity pressures, this could be USD negative at the margin, but we’re unsure of the market impact. Deeper read here.

Guidance on the cut itself – is this positioned as a one-off cut or the likely beginning of a series of cuts? Given where asset markets are trading, the Fed may not want to encourage asset market froth, but then again, any linking of policy to other factors, like the strong USD, would allow the market to draw its own conclusions that the Fed will continue to cut.

President Trump response – it is hard to imagine the Fed doing enough to please President Trump, who will be on the warpath if the USD moves higher and if the Fed doesn’t halt QT immediately. Trump will want to impress generally to have the most impact – threatening to weaken the USD by force and not just scapegoating the Fed. The promise to directly intervene, threaten investigations and/or trade sanctions are all possible. This could make for rocky trading.

Upcoming economic data – the narrative could shift quickly no matter what the Fed does if we see notably weak US data in the ISM surveys this week and the July jobs report on Friday, which would accelerate the sense that the Fed remains behind the curve here. But this might only be USD negative potentially in USDJPY as a weak US economy could eventually start to creep into risk appetite more generally.

Market reaction
The real key here will be in the market reaction to whatever the Fed delivers. If we merely get the expected 25 basis point cut and a weak commitment to cut further, with little or no discussion of the other factors mentioned above, the USD is likely to strengthen further (though this will almost guarantee a Trump response that will disrupt the move). To cap the USD here, the Fed will have to make a stronger statement on the balance sheet and perhaps linking adjustment to USD liquidity issues, i.e., stopping QT immediately. Our assumption is that a 50 basis point move is highly unlikely – but would have a reasonably strong impact if QT also halted. 

Goings on elsewhere
Sterling has stabilized as the UK-EU standoff continues. We consider it likely that Boris Johnson has staked everything on not backing down, so the softening in the stance will have to come from the EU side.  We have no expectations for the BoE tomorrow, nor does the market.

China’s official July PMI’s were a mixed bag, with the manufacturing survey improving slightly, but still pointing to contraction at 49.7, while the Non-manufacturing survey slid to 53.7, it’s lowest level since December. A Reuters article yesterday  suggests that China’s pig herd may require a reduction of 50% to deal with the outbreak of African swine fever.

Sweden reported a weak growth number yesterday, with the quarter-on-quarter Q2 GDP at. This is right on schedule with the household lending growth dropping below. There is no monetary policy room to do anything about it in Sweden, where it is only a fiscal response or an improvement in external demand that is likely to lift growth materially from here. 

Australia’s quarterly CPI number came in a smidge higher than expected, with both the headline and “trimmed mean” out 0.1% higher than expected at 1.6% and 1.6% year-on-year, respectively. This boosted the Aussie ever so slightly, as the market shifted the odds a bit on whether the RBA cuts again in August or September. The AUD rally was a bit sharper versus the kiwi, as New Zealand reported a weak ANZ survey. Is AUDNZD finally building a base around 1.0400? Hard to maintain interest lately with moribund price action, but we are looking for an eventual repricing higher.

The Bank of Japan was a nonevent as expected

Upcoming Economic Calendar Highlights (all times GMT)

• 1100 – Mexico Q2 GDP
• 1215 – US Jul. ADP Employment Change
• 1230 – Canada May GDP
• 1345 – US Jul. MNI Chicago PMI
• 1800 – US FOMC Rate Decision
• 1830 – US Fed Chair Powell Press Conference
• 2100 – Brazil Selic Rate