Hawkish guidance from Fed is no game changer for USD if not back up by data

USD: Will the Fed will deliver two more hikes as planned? 

The US dollar has continued to trade at modestly stronger levels during the Asian trading session following yesterday’s FOMC meeting. The dollar index had fallen as low as 102.66 yesterday just before the FOMC meeting and has since hit a high of 103.36. US dollar strength has been mainly evident against the yen which is more sensitive to Fed rate hike expectations. It has lifted USD/JPY to a fresh year to date high overnight of 141.43 as it continues to move further above yesterday’s low of 139.29. The move higher in USD/JPY and the US dollar more broadly has been encouraged by the continued adjustment higher in US rates. The 2-year US Treasury bond yield initially jumped higher by around 13bps to a peak of 4.76% just after the Fed’s policy announcement was released and has since stabilized at higher levels. The move higher reflects market expectations moving to price in a higher probability of at least one more Fed rate hike this year. At last night’s policy meeting, the Fed left rates on hold but the accompanying guidance was more hawkish than expected. It was still the first time that the Fed decided not raise rates at a policy meeting since the current tightening cycle began back in March of last year.  The policy statement highlighted that the decision to leave rates on hold at this meeting “allows the Committee   to assess additional information and its implications for monetary policy”.  In determining the extent of additional policy firming that may be required, the Fed will continue to take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

The main hawkish policy surprise was the updated dot plots which revealed that the majority of FOMC participants now favour raising rates two more times by the end of this year. It sent a stronger than expected signal that further rate hikes are likely and that the decision to leave rates on hold overnight was not the end of the hiking cycle. The median projection for the Fed funds rate at the end of this year rose from 5.1% up to 5.6%. Nine out of eighteen FOMC participants favoured raising rates two more times this year with three even favouring raising rates by more. Further out the Fed still expects to begin lowering rates next year with the median projection for the Fed funds rate at 4.6% at the end of next year. It implies one more rate cut next year than planned back in February although there is a wide spread of views amongst market participants.

The Fed’s decision to signal that more hikes maybe required was encouraged by the updated forecasts for higher inflation and a tighter labour market. Core inflation was revised by higher 0.3ppt for the end of this year to 3.9%, and the unemployment rate was revised lower by 0.4ppt for the end of this year to 4.1%. The hawkish guidance has been partially taken on board by the US rate market which is pricing in 17bps of hikes by July and 22bps of hikes by September. We would agree with the US rate market’s caution to more fully price in two more hikes at this stage although we acknowledge that there is a much higher probability now of at least one more hike in July. It is not a done deal though if activity and inflation data is weaker as we expect in the coming months. The release this week of the softer US CPI and PPI reports for May have given us more encouragement that the Fed should bring an end to their hiking cycle soon as evidence of disinflation pressures continue to build.

The comments from Fed Chair Powell in the press conference were also less hawkish than the policy guidance provided by the updated dot plots. He emphasized that proceeding at a more “moderate pace” would allow the Fed to learn along the way and reduce the likelihood of a big policy error. When asked specifically about hiking rates again in July, he said that the July meeting was “live” but not pre-decided. He also suggested that conditions for further disinflation were “coming into place. Overall, the Fed’s policy update has not significantly altered our view that the Fed is close to the end of their hiking cycle. While the Fed may now deliver one final hike in July, we remain unconvinced over the need for a second hike and believe that weaker activity and inflation data will encourage the Fed to signal that sufficient tightening has been delivered either at Jackson Hole over the summer and/or at the September FOMC meeting. As a result, we don’t expect the US dollar rally overnight to extend much further unless backed up in the coming months by upside surprises for US  activity and inflation data.

EVIDENCE OF DISINFLATION IS CLEAR IN PPI REPORT  

Source: Bloomberg & Macrobond

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
EC	13:15	Deposit Facility Rate	Jun	3.50%	3.25%	!!!
US	13:30	Initial Jobless Claims	--	250K	261K	!!!
US	13:30	Retail Sales (MoM)	May	-0.1%	0.4%	!!!
EC	13:45	ECB Press Conference	--	--	--	!!!

Source: Bloomberg