Cautious Fed sends USD lower

As broadly expected the Federal Reserve increased rates by another 25bps and adopted a cautious approach during its June meeting. After spending most of Wednesday grinding lower, the greenback appreciated sharply in the minutes before the announcement but erased those gains immediately as investors realised nothing has changed. It is true that the statement underwent significant change as the FOMC removed the ‘forward guidance’ part, which was a remainder of the financial crisis.

Regarding the dots plot, it didn’t change much as well. Fed members continue to signal two more rate hikes for 2018, most likely in September and December. Nevertheless, he said that interest rate decisions are not on autopilot and can adapt to unexpected development of the economy, which gives the Fed flexibility to stay sidelined should the economy need a breather.

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Powell carefully avoided mentioning the trade war initiated by Donald Trump, even though it could have significant consequences for the US economy and recalled that trade policy is not part of the Fed mandate.

In the FX market, the buck is losing ground against all its G10 peers, with the exception of the Australian dollar that is suffering from trade war uncertainties and weak Chinese data. With the Fed is already in the rear view mirror, investors are impatiently awaiting this afternoon ECB meeting.

ECB focuses on ‘normalization’

Today’s European Central Bank meeting is critical. ECB board members have been quiet on normalization, so it should provide insight into the minds of Draghi & Co for any quantitative-easing tapering or interest hikes. Last quarter’s decelerating European growth will hurt the GDP outlook. Weak prices are sending core inflation back towards cycle lows. ECB’s corporate line is that risks are transitional and balanced. But given the soft-patch, no one would be confused by an ECB pause in hawkishness. With economic worries haunting, the risk is increasing that an anticipated June or July decision of tapering might be delayed.

Meanwhile, political risk and hype is building in Italy, Spain and Greece, which might change the ECB’s mind. The recent, sharp rise in interest rates on the periphery suggests tighter finances for the region’s weaker nations. However, the threat of a shock will only strengthen the ECB’s desire to get policy off the bottom, because it has few options to manage a crisis. Rates are already negative and bond buying is running into supply shortages. As with the US Federal Reserve in 2013, the need to remove extreme policy, to regain policy firepower, outweighs temporary economic weakness. Given the weakness in EUR/USD, the market is underpricing ECB’s commitment to ‘normalization.’

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