USD Uptrend Steady Before FOMC; GBP Risky Ahead of BOE
- Fed funds are pricing in a 0% chance of a rate move today, which isn't a surprise considering policy officials have all but explicitly said that the next hike is coming in December.
- Asymmetric risk exists for the British Pound around the BOE rate decision tomorrow, given the high degree to which a rate hike has been priced-in (89% per overnight index swaps).
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The US Dollar (via DXY Index) is holding ground for the fourth consecutive day, trading at 94.64 at the time this note was written, the same level it closed at after the ECB rate decision last Thursday. Even though the Federal Reserve will release its November rate decision and policy statement today, it doesn't look like the US Dollar will be bothered one way or the other.
The Fed is one of these central banks that prefers to make major policy changes at meetings in which they have press conferences for their central bank head to soothesay market participants. The BOE (making changes at meetings with new Quarterly Inflation Reports) and the ECB (at meetings with new Staff Economic Projections) fall into this category as well: the ECB's October taper was essentially pre-announced at their September policy meeting.
Chart 1: DXY Index Daily Timeframe (June to November 2017)
So today, with neither a new Summary of Economic Projections nor a Janet Yellen press conference, the Fed won't do anything meaningful at all.
Instead our attention should be on the widely-anticipated Bank of England rate hike tomorrow, which is pretty much set in stone. According to markets (overnight index swaps) there is an 89% implied probability of a hike. In support of this point of view, since mid-August, economic data trends have firmed up (the Citi Economic Surprise Index was -51.9 on August 15, today it is +5.7). The 'big one' that the BOE has everyone talking about is headline inflation, currently sitting at +3% y/y.
However, the inflation outlook going forward looks less severe. One of the main reasons for the spike in inflation was the base effect in the trade-weighted GBP brought on by Brexit. Now that the GBP is up y/y (it bottomed in early-October 2016 post-Brexit vote), BOE policy officials think headline inflation will begin to recede naturally.
I'm partial to think that the market is right here, given that I have no information to suggest otherwise. But on the rate hike scale, I'm on the 'dovish end': if the BOE hikes, it won't be the beginning of a rate hike cycle.
The UK is facing a pseudo-/mini-stagflationary state right now. Sure, the labor market is doing well (which is why this is not true staglfationary state). But inflation is high and growth is weak, leaving the BOE in a conundrum: raise rates to stave off inflation at the risk of choking off growth; or keep rates lower for longer to keep growth conditions primed and hope that the recent base effect of the GBP limits further upside to inflation.
Chart 2: GBP/USD Daily Timeframe (August 2016 to November 2017)
With an 89% implied probability, much of the upside is priced in. Likewise, given my outlook for a 'one-and-done' hike, the forward guidance on rates shouldn't be that helpful for the Sterling. Thus, there is asymmetric risk for the British Pound tomorrow: limited upside potential, greater downside potential.
If we get the 'hawkish hike', GBP/USD could trade into the mid-1.3300s; the base case for a 'dovish hike', which could send GBP/USD back towards 1.3100; and in the event that there is no hike, GBP/USD could slip below 1.3000.
--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
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