US Dollar Aims Higher on Upbeat Fed, Pound to Overlook UK Budget

Talking Points:

• US Dollar to rise as commodity FX weakens on hawkish FOMC
• Pound to look past UK budget given limited impact on BOE bets
• Yen edges lower overnight as prices correct after post-BOJ rally

Most of the major currencies were little-changed in overnight trade as investors waited for the much-anticipated monetary policy announcement from the Federal Reserve before committing to a firm directional bias. The Japanese Yen edged lower as prices corrected having put in the largest advance in the week following yesterday’s BOJ rate decision.

The rate-setting FOMC committee is widely expected to pass on changing policy this time around. Fed Funds futures imply a 94.2 percent probability of staying within the current 25-50 basis point range for the benchmark lending rate. This puts the spotlight on forward guidance and the mismatch between the central bank’s outlook and that of the markets.

Policymakers have made notable progress on their mandate. The unemployment rate has dropped to an eight-year low of 4.9 percent while the Fed’s favored core PCE inflation gauge hit a three-year high at 1.7 percent in January. Critically, this doesn’t account for easing headwinds from the exchange rate and crude oil prices in February, meaning inflation is probably closer still to the target 2 percent.

This seemingly makes for a convincing rate-hike argument. The markets remain skeptical however. When the Fed projected 100bps in 2016 tightening in December, traders envisioned just 50bps. Subsequent market turmoil made matters worse. After briefly dropping rate increases from the outlook entirely last month, investors now see one 25bps increase before year-end.

On balance, this seems to tactically compel the Fed to stay its hand. The disconnect between the officials’ view and that of investors means tightening now would probably trigger panic. This sets up the March FOMC meeting as an opportunity to lay the ground work for the resumption of stimulus withdrawal later in the year.

The task before the Committee is a formidable one. They will need to be reassuring yet decidedly hawkish to avoid unwanted volatility while pushing markets to acclimate to a steeper rate hike path. This likely implies a rates forecast calling for 50-75bps in tightening, an upgrade of the inflation outlook and a cautiously optimistic tone in the policy statement as well as Chair Yellen’s post-meeting press conference.

At surface level, such a scenario bodes well for the US Dollar. In broader terms, the close link between liquidity conditions and sentiment trends implies a hawkish tone will weigh on risk appetite. This is likely push the Australian, Canadian and New Zealand Dollars lower alongside stock prices.

The unveiling of the latest UK budget by Chancellor of the Exchequer George Osborne is in focus in European trading hours. Another dose of austerity is expected as the government tries to fulfill its pledge for surpluses by 2020. Osborne already pointed to £4 billion in spending cuts this week. On revenue, the Chancellor will have to get creative to sidestep a 2015 election promise not to raise the main tax rate.

From a trading perspective, the bottom line is that fiscal policy will not offer meaningful support to economic growth in the year ahead. This likely translates into a more dovish posture from the Bank of England by pushing rate hikes further into the future. While this amounts to a headwind for the British Pound, the absence of near-term tightening bets is likely to make for a muted response from price action.

Are FXCM traders long or short the US Dollar ahead of the FOMC rate decision? Find out here !

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--- Written by Ilya Spivak, Currency Strategist for DailyFX.com

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