USD better bid ahead of Fed decision
The demand for US dollar rose on Wednesday as investors await the outcome of the June FOMC meeting. Despite the fact that there is no question the Federal Reserve will increase short-term interest rates by another 25bps, which would bring the target band to 1.75% – 2%, investors remain cautious amid uncertainties regarding a potential shift in expectations for future policy. Indeed, FOMC members are due to provide updated economic and financial forecasts.
According to official data, the US economy is on a solid footing with inflation rising towards the Fed’s 2% goal and accelerating GDP growth rate. However, we believe that Fed officials won’t get ahead of themselves and will adopt a precautionary approach as many uncertainties remain. Primarily, the Fed started to unwind its giant $4.5tn balance sheet just a few months ago and it will take a few more months to see the effects of this reduction of dollar liquidity on the market. Secondly, the impressive improvement in the job market have not translated into an increase in real wage yet. Despite improvement in nominal wages, the increase in inflation pressure hurt has eroded wage gains. On an inflation-adjusted basis, US wage growth eased for a second straight month in May as it rose only 0.3%y/y, compared to 0.4%y/y in April.
We anticipate the FOMC members will signal one more rate hike this year, most likely in September, as well as a moderate upward adjustment in their growth forecast. Modification of inflation expectations should be more cosmetic. Overall, we think that Fed members will start considering a slower path of tightening as the effect of balance sheet unwinding will start to kick in.
Short the yen
USD/JPY and EUR/JPY should be reloaded now This week’s Bank of Japan policy decision will be to hold rates. USD/JPY continued to strengthen ahead of critical US Federal Reserve and BoJ meetings. The BoJ has made it clear: no change should be expected. In addition, the trade dispute with the US has caused some distortion in the market pricing of the Euro. Monetary policy divergence remains the primary drive in USD/JPY positioning.
Inflation is far off target, and the BoJ has said that changes would materialize only when inflation reaches the bank’s target. Growth has also disappointed, led by weakening private demand, indicating a target-hit is also unlikely next year. Investment and consumptions could easily correct lower should, weighing on wages and prices, should the market feel that the stimulus is now causing stocks to fall. Therefore, further easing could be on the table to prop-up asset prices and confidence. Finally, the political threat to Prime Minister Abe and ‘Abenomics’ has faded. With a firm grip on power, Abenomics could fire up again.
