The FX Trader: FOMC uncertainty weighs, market tilting for hawkish outcome.

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FOMC on tap with a side of geopolitical distractions. The focus at the start of the week Monday was on the sudden de-escalation of US-Iran hostilities after last Thursday saw a spike in crude oil prices to over USD 100 per barrel in Brent crude. Monday suggested that even an 8-dollar-per-barrel decline in crude oil is only worth about a 0.25% knee-jerk sell-off in the US dollar in the major crosses. So EURUSD consolidated back as high as 1.1418 Monday before rolling back well below 1.1400 again and towards the lows of this month, as the main focus this week remains on the FOMC meeting and whether the Warsh-led Fed will pull the trigger on a rate hike this week—about 35–40% priced as of early European trading hours on Tuesday.

The frustrating angle, with or without a rate move, will be the Fed attempting to avoid providing forward guidance on its future moves, but the market will interpret every little hint regardless. Even if the Fed skips a hike at this meeting, does the market merely assume that it is a timing issue and that we should remain fully priced for a 25-bp hike at the September FOMC meeting? If the Fed does go ahead with the hike on Wednesday, the forward curve will likely shift higher unless the interpretation is somehow that this was an insurance hike until “better” inflation data from Warsh’s task forces are available—although, again, that latter interpretation requires some degree of interpretation of the monetary policy statement and Warsh’s rhetoric at the presser. It all feels a bit treacherous and murky, especially in a low-energy market.

Bottom line: While this Fed is all about “no forward guidance”, the market will still do whatever it can to interpret the Fed’s observations on the quality of the economy and inflation. A rate hike will read initially as a hawkish surprise, just as a pass on moving the rate will see the market reducing the expected hawkish potential of this Fed. The reaction function may be equally large in either direction: the market is leaning towards a hawkish outcome and a stronger US dollar, but it is not fully priced for a rate hike, and some further premium for another hike might have to be added to forward expectations. On the other hand, a pass not only deflates expectations for future rate moves, but also goes against the market “lean”. Another thing to watch for: could Warsh announce that the dot plots or SEP will no longer be published from September onwards?

Bank of Japan signalling important after GPIF moves failed to ignite a JPY rally. The Bank of Japan is not expected to hike the policy rate at this Friday’s meeting, with odds rising to around 30% for a September hike. For the remaining three BoJ meetings of the year after this week’s meeting, through mid-December, 25 basis points of further tightening is priced. It is notable that the front end of Japan’s government bond yield curve perked up considerably last week, rising 7–8 basis points and flattening the yield curve as more tightening was priced. Could the great Japanese yield-curve steepening of the last two years finally be turning lower? With US Treasury yields rising of late, it would take a lot of heavy lifting from the BoJ to make a dent in US-Japan rate spreads.

A key recent development that was somewhat tantalising for hopes of a JPY comeback was the news—first on 10 July from Finance Minister Katayama and later on 17 July via statements from Prime Minister Takaichi—that the government would encourage households and public pension funds, most notably the massive GPIF, to invest more in Japanese assets. The 10 July announcement triggered a one-off JPY rally, but nothing yet suggests that the government is ready to strong-arm the situation. The GPIF president said yesterday that the JPY 293 trillion fund—about USD 1.8 trillion—would manage its assets in the long-term interests of its beneficiaries, which waters down the impact of the earlier official announcements.

Bottom line: As discussed in the look at the USDJPY chart below, the market is not anticipating much from USDJPY this week over the FOMC and BoJ meetings. It will therefore take either a dovish FOMC turn, a considerably hawkish BoJ turn, or both to trigger a significant JPY rally. Still, I am on the lookout for the JPY to rally somewhere in the coming weeks on valuation, firmer government signalling on asset-allocation policies, or both—not to mention the relative normalisation of Japan’s yields versus global peers. Again, technically there is nothing to indicate a turnaround just yet, so let us see where we end the week.

Chart focus: USDJPY
USDJPY may have considerable volatility potential this week in the wake of the FOMC meeting on Wednesday and the Bank of Japan meeting on Friday, although one-week USDJPY options-market implied volatility has only perked up to the middle of the range of the last two months. The US dollar is firmly in the driver’s seat, pulling the pair higher whenever US Treasury yields rise, so a dovish FOMC turn is likely needed as a first step towards any major consolidation in USDJPY in the near term. The Bank of Japan remains ponderous in its rate-normalisation process in the meantime. The first downside level of note is the prior high at 162.84 from the beginning of this month, but a much sharper break lower would be needed even to signal meaningful softening, let alone a reversal of the uptrend.