In 24 hours the Federal Reserve will announce its monetary policy decision and everyone expects interest rates will remain unchanged. The Fed has done a great job of preparing the market for steady rates but no changes to monetary policy doesn’t mean no volatility for the U.S. dollar.
The reason why the April FOMC meeting is important is because it will help to shape expectations for June. There’s no monetary policy in May so if the Fed wanted to prepare the market for possible tightening, they would need to tweak this month’s FOMC statement. The problem is that the odds of a dollar positive and negative outcome is roughly balanced. With the global markets stabilizing and commodity prices moving higher, the Fed has less to worry about internationally but domestically, growth has slowed. So even though no changes in monetary policy is expected at this month’s meeting, the greenback could still have a meaningful reaction to FOMC based upon the Fed’s assessment of the economy.
Now lets run through the possible scenarios:
Scenario 1 – The FOMC statement remains virtually unchanged = Mildly negative for the dollar because it would imply an ongoing split within the Fed and reluctance to raise interest rates.
Scenario 2 – Fed acknowledges deterioration in data and leaves out risk assessment = Dollar Bearish
The balance of risks statement was removed from the last 2 monetary policy statements because policymakers could not agree on the outlook for the economy. So if the risk statement is absent again, the dollar could spiral lower as the market interprets it to mean no rate hike in June.
Scenario 3 – Fed acknowledges deterioration in data but describes it as transitory AND the risk statement returns = Dollar Bullish
If the risk statement reappears and the Fed describes the risks are balanced, the dollar will soar as the chance of a June hike increases significantly. Aside from the risk statement the central bank’s comments about recent data disappointments will also be important. If they say the deterioration is transitory, it will help the dollar.
The following table shows how the U.S. economy performed between March and April. An initial glance shows more deterioration than improvements with consumer spending, labor market activity, inflation, production and trade weakening. However there are glimmers of hope. The rally in U.S. stocks helped to boost consumer confidence as measured by the Conference Board’s report, consumer prices are still moving upwards as gas prices increased. New and pending home sales rebounded and most importantly manufacturing and service sector activity accelerated. With average hourly earnings on the rise, the Fed could argue that the economy will regain momentum in the near future and with prices rising, they need to get ahead of inflation expectations. In other words while the data suggests that the Fed should be less hawkish, they could also find reasons to stick to their plan of raising rates twice this year.
Thursday’s ECB meeting is one of the most important event risk this week. EURO has been biding its time trading between 1.1235 and 1.1475 pre-ECB. Which end of this range breaks hinges upon Mario Draghi’s tone. If he’s concerned about the strong euro and talks about the possibility of more stimulus, then 1.1235 could give. If he simply says they need more time to see the effects of stimulus and points to recent data improvements as a sign of their easing measures working, euro could break 1.1400 and aim for recent highs.
The following table shows how the eurozone economy changed since the ECB last met – from a data perspective, the central bank has less to worry about in April vs. March when there was significantly more deterioration than improvement. So the question is whether the 3 to 6 cent rise (depending where you’re measuring from) in EURO since easing rings alarm bells for the central bank.
The Bank of Canada meets tomorrow and based on the following table, they have more reasons to smile this month with consumer spending and job growth improving significantly. Oil prices are also up 10% since March and the slowing down of Fed tightening will remove some of their worries about the outlook for Canada’s economy. So chances are the BoC rate decision will be positive for the Canadian dollar
Between an emergency Fed meeting, the Bank of England and Bank of Canada monetary policy announcements, US retail sales, Chinese GDP, Australian employment, UK consumer prices and a host of other tier 1 event risks, there are no shortages of events that could drive big moves in currencies.
However, the #1 driver of FX flows this week will be risk appetite. That could be driven by the swings in commodity prices, the volatility in equities, Chinese and/or US data. At the end of this week on Sunday there’s a production freeze meeting in Doha and we are already beginning to see headlines about some producers refusing to cut production. One of the main reasons why commodity prices are performing so well this morning is because crude oil is above $40 a barrel.
Chinese data will also be important. Consumer prices were released last night and the stronger report propelled AUD/USD above 76 cents. Tuesday evening, Wednesday morning local time Chinese trade numbers are scheduled for release and on Thursday evening / Friday morning, Chinese industrial production, retail sales and Q1 GDP numbers are due. We are beginning to see signs of stabilization in the world’s 2nd largest economy but according to China Premier Li, the downside pressure on the economy remains.
And of course there’s Wednesday’s U.S. retail sales report – the market detests dollars but a blowout report could help to turn things around.
Keep an eye on the VIX:
We have now seen the dollar fall approximately 600 pips against the Japanese Yen in just over week. Alarms should be ringing at the Ministry of Finance and Bank of Japan because the 5% appreciation spells big trouble for Japan’s businesses and economy. However, everything that we have heard from the Japanese government so far suggests that they are not ready to intervene in the foreign exchange market to lower the value of their currency. The last time the Bank of Japan intervened in the currency was in 2011 after the earthquake and tsunami (and that was coordinated). Since then we have seen USDJPY fall as low as 76 and average around 102.25 over the past 4 years. So Japan has and can tolerate a stronger yen although they have less flexibility with monetary and fiscal policy because extensive action has already been taken through these years.
While we believe the Japanese government should intervene given the weakness of the currency, there are a number of reasons why they won’t:
- They could be waiting for the G7 meeting
- They could be waiting for fresh fiscal stimulus
- They could be waiting for the markets to capitulate first.
- They could also be looking into monetary stimulus rather than direct intervention to avoid being singled out for competitive devaluation of their currency at the G7 meeting in late May – because the host never wants to be embarrassed.
On a fundamental basis, it is becoming clear that the BoJ could allow USD/JPY to fall to 105 and maybe even 100 before taking action. In early February they let USD/JPY fall close to 1100 pips before there was also indication of intervention. While it has not been confirmed on February 11th, after dropping to a low of 110.98, USD/JPY jumped 200 pips in 20 minutes – price action that is indicative of intervention. USD/JPY still has 500 pips to go before this capitulation point, which would put the pair right between the 100 and 105 level. However we would be surprised if the BoJ let USD/JPY fall 1000 pips from its March 29th high of 113.80 without checking rates near 105.
On a technical basis, there’s no support in USD/JPY until 106.63, the 38.2% Fibonacci retracement of the 2011 to 2015 rally. We expect USD/JPY to test and bounce off this level. However if the Fib is broken then it should be smooth sailing down to 105.85, the 200-month SMA. So while the Bank of Japan could allow USD/JPY to drop 1000 pips from its recent high, there are enough key technical and psychological support levels between now and then to make it a choppy and not one-way move.