Central Bank Weekly Talking Points:
- The DXY Index broke out to a fresh yearly high earlier this week, although price action on Friday is suggesting that a false breakout has transpired.
- With the new Trump tariffs, Fed funds futures now see a 78% chance of 75-bps of rate cuts by the end of 2019 – up from 56% prior to the July Fed meeting. Meanwhile, Eurodollar contract spreads have become more dovish, now predicting an 85% of 75-bps of rate cuts by the end of 2019.
- Retail traders are selling the US Dollar ahead of the July Fed meeting.
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The last week of July and the first few days of August have proved to be monumentally important for the US Dollar (via the DXY Index). As the Federal Reserve opted to only cut rates by 25-bps at their July policy meeting, US President Donald Trump, who has repeatedly called for looser interest rates, has now cultivated a situation where the Fed’s hand may be forced.
Indeed, with the US delegation canceling trade negotiations with their Chinese counterparts on Wednesday and the surprise announcement for another 10% tariff on $300 billion of imported goods on Thursday, market participants now see the US-China trade war as getting worse before it gets better.
In turn, while the US Dollar initially benefited by a less dovish Fed than some market participants were expecting, the developments in recent days have convinced traders that the Fed will continue down the dovish policy path for the foreseeable future.
Fed Rate Cut Odds Rise Again after Latest US-China Trade War Developments
For the past several weeks, we’ve said some variation of, “Regardless, markets feel that if the Fed rate cut cycle is about to begin, it will do so in aggressive fashion over the next several months in direct response to the US-China trade war.” Following the latest round of Trump tariffs, Fed rate cut odds are once again frontloaded.
Federal Reserve Interest Rate Expectations (August 2, 2019) (Table 1)
Prior to the July Fed meeting, Fed funds futures were discounting a 76% chance of another 25-bps rate cut in September and a 56% chance of a third and final 25-bps rate cut in December 2019. Less than 48-hours after the July Fed meeting, Fed funds futures are pricing in a 100% chance of a second 25-bps rate cut in September and a 62% chance of the third 25-bps rate cut in October (not December).
Rates Markets Comfortably Discounting Two More Rate Cuts in 2019
With Eurodollars contract spreads, we can measure whether a rate cut is being priced-in by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future. The chart below showcases the difference in borrowing costs – the spreads – for the June 19/December 19 (blue), August 19/December 19 (orange), & August 19/June 20 (red) periods in order to gauge where interest rates are headed by the end of December 2019 and the end of June 2020, respectively.
Eurodollar Contract Spreads – June 19/December 19 (Blue), August 19/December 19 (Orange), & August 19/June 20 (Red): Daily Timeframe (July 2018 to July 2019) (Chart 1)
Based on the Eurodollar contract spreads, there is an 88% chance of a second 25-bps rate cut by the end of 2019. To this end, if a third rate cut comes from the FOMC, Eurodollar contract spreads see a greater likelihood of that happening by June 2020; there is a 100% chance of 50-bps of rate cuts coming through the first half of next year.
Overall, Fed funds remain more aggressive than Eurodollar contracts in their dovish pricing for the Fed rate cut cycle. We’ve previously noted that “such dissonance [between Fed funds and Eurodollars] typically yields volatility,” and this week has proven no different. Expected elevated levels of volatility across USD-pairs moving forward.
DXY INDEX TECHNICAL ANALYSIS: DAILY PRICE CHART (NOVEMBER 2017 TO AUGUST 2019) (CHART 2)
Fed rate cut odds have jumped since the July Fed meeting, no thanks to the July US nonfarm payroll report but rather the introduction of a fresh round of Trump tariffs in the US-China trade war. In turn, he US Dollar (via the DXY Index) is now threatening a false breakout.
A false breakout here would occur at critical resistance in the form of (1) former trendline support from the February 2018 and March 2019 lows and (2) the bearish daily key reversal bar set at the former yearly high at 98.37. A close at current levels or below would mark such an occasion.
To this end, if the DXY Index were to close below the daily 8-EMA, which it hasn’t done so since July 19, there would be more credible evidence to believe that the near-term rally is finished.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
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