Fed chair to force the dollar's hand

The equity market staged an aggressive rally higher through key resistance yesterday ahead of today’s testimony from Federal Reserve chair Jerome Powell, possibly regarding the Friday Monetary Policy Report as a tip-off that the Fed isn’t set to get tough on countering late-cycle inflationary pressures with a steeper path of rate hikes from here. A solid rally in US Treasuries over the last few sessions would underline this. 

On Monday, new Fed board of governors member Quarles was out speaking on the economy and Fed policy and he failed to make any alarming noises. While suggesting that the tax reform and other fiscal measures are likely to lead to a strong upswing in economic growth, he suggested that Fed rate hikes would remain gradual with very little concern on the inflation front... sounds like Mr. Quarles is selling Goldilocks. 

Regarding Powell’s testimony today I think the market may be too complacent on the makeup of the new Fed chair, who may clearly prefer to have more leeway in establishing Fed policy. To get that, he will need to introduce uncertainty rather than declare that he is particularly hawkish. Given that the market has become so accustomed to the forward guidance hand-holding from the Bernanke/Yellen era, this could yet derail the attempt by equity markets to come full circle from the volatility event of the last month. 

I have flip-flopped on the tactical USD outlook, but there could be a risk of a sharp USD consolidation higher if the Fed puts the market on notice that the Powell put has a lower strike price than the Bernanke or Yellen variety and equity markets take heed and correct again after their fresh break of resistance. 

If Powell recycles all the gradualism on Fed hikes, lack of concern on inflation, and asleep-at-the-switch language on financial stability, on the other hand, USD bears would likely pounce with abandon. There are shades of gray between the two outcomes outlined here, of course.

Sterling’s modest recent rally was halted dead in its tracks yesterday, possibly by a story that the EU will present a comprehensive 100-page draft of a Brexit deal that will fail to include some key demands the UK side was hoping to have included in the eventual deal, like the length of the transition phase and a compromise on the Irish border issue.

Chart: EURUSD

EURUSD has gone completely flat over the last few sessions, possibly in anticipation of Powell’s testimony today. The pair needs to break either way and a strong close in either direction could set the direction for several days to come. This depends on whether Powell cuts a strong figure by attempting to make the Fed forward guidance less set in stone and more dynamic, or whether he peddles the USD-bearish Goldilocks message of growth, gradual rate hikes, no inflation concerns, and no financial stability issues.