Last thoughts ahead of FOMC

Yesterday’s announcement from US President Trump that he would have an “extensive meeting” with China’s Xi Jinping sparked a flurry of market activity, punching the US dollar lower and throwing gasoline on an equity market rally that was earlier sparked by dovish comments from European Central Bank President Draghi.

Speaking at the ECB Forum in Sintra, Draghi let loose with a dovish broadside touting the bank's ability to continue cutting rates and noting plenty of headroom for QE if needed. EU rates markets took note and priced another seven basis points or so of easing by year-end, so that a 10 basis point cut is fully priced by then and some forecasts are shifting to an even lower policy rate than the implied -0.50%. The futility of it all is astounding, but Draghi perhaps figures that, with nothing to lose as he will be leaving the scene at the end of October anyway, he may as well shoot all of his remaining ammunition.

While Trump’s announcement that he will meet with Xi does bring a new angle to tonight’s FOMC meeting, it may not do much to alter the message the Fed will deliver tonight. My general stance ahead of tonight’s FOMC meeting is that the Fed will have a hard time bringing an overall dovish surprise relative to the market’s comprehensive forward rate expectation adjustment.

To divide that  up a bit, I suspect the Fed will more or less deliver what the market is expecting for the near term (indication of a tilt in favour of a July rate cut and adjustment to the statement to remove the  word “patient”). As for the pricing of the Fed’s rate schedule beyond July, the Fed may have a hard time delivering a message that offers clear evidence it expects to cut as much as the market now expects. Exhibit One in that regard will be the dot plot and Powell’s stance during the questioning. Another way the Fed could shift expectations, however, is to bring the US dollar into the discussion as an indicator the Fed is closely watching, given that the Fed’s own measure of the USD is near its highest level since 2002..

The USD reaction may prove clearest if the market draws the conclusion that it has over-baked its expectations for the Fed policy path from here, at least versus riskier currencies – that being said, confidence in the reaction function is low as the USD has generally maintained altitude well despite the drastic repricing. One of the few correlations that has held well has been the link between long US yields and USDJPY, as we discuss with the chart below. 

Chart: USDJPY

The market that has moved most aggressively ahead of the FOMC has been the US treasury market, with the entire curve shifting sharply lower over the past couple of months. USDJPY has reliably taken its cue from long US yields, so any “sell the fact” reaction in US treasuries (higher US yields) could set the USDJPY on a consolidation path back higher, with the first overhead level of note around 109.00. The Bank of Japan does meet tomorrow but is unlikely to surprise.