Fed likely to be dovish

The June FOMC statement is announced at 04:00 AEST and expectations are largely that the central bank will be dovish in its language.

Pound coin and dollar
Source: Bloomberg

Better buying has been seen in the US 500, but the real test will be if we can see the May downtrend broken at 2,110. This development would also suggest a move above 50 in the RSI’s and a MACD crossover, suggesting momentum is looking more bullish. From here, I would expect a move into the 2,140 area and it seems the market is quite accustomed to market friendly rhetoric from the Fed chairman with the S&P 500 having rallied around 80% of times when we see a press conference during Ms Yellen’s tenure.

The US dollar index has been modestly offered of late and is actually 0.4% lower from the prior FOMC meeting. This weakness in the US dollar index is a function of EUR strength. This is despite the fact that there is a deteriorating picture in the Greek debt negotiations and there is now a real prospect we get capital controls on the Greek banking system as early as this weekend, akin to Cyprus in 2013.

Traders have been using moves into the $1.1350 area on EUR/USD to initiate short positions but for the EUR to really come under pressure we will, rather perversely, need to see European equity markets rally and risk appetites to increase. The key here is that during Q4 14 and Q1 15 investors heavily accumulated holdings in European equities and bonds and hedged out their euro exposure on an on-going basis. As European equity markets have been aggressively sold of late - and subsequently the capital base decreases - money managers need to buy EUR’s in line with the necessary hedging strategies.

Some have made the connection that a future ‘Grexit’ could actually result in a stronger EUR as the fiscally weak nations exit and the EUR gets closer to the Deutschemark. There is merit here, but for now the key driver are money managers hedging policies.

Back to the FOMC meeting

It’s hard to get a clear grip on the highest probability outcome for tonight’s FOMC meeting. However, I suspect we could see EUR/USD lower if the Fed leave its projections for the Fed funds rate at 62.5 basis points for December. Looking at current market pricing, the market is speculating that the fed funds rate should be closer to 35 basis point by year end.

Further to this,  we have actually seen this instrument fall three basis points this week suggesting a modest pricing out of expectations, which is USD negative at the margin. Given the vast market divergence it seems logical that keeping its current projection at 62.5 basis points would send a strong signal that the US central bank will look to lift the funds rate in September. This is consistent with the market pricing a 47% chance of a move in September, which is down from 53% last week.

As things stand, the Fed’s current projection is for 2.5% growth in the US economy this year. Given the 0.7% contraction in the first quarter we will need to see GDP average 3.5% in each of the following three quarters for their estimate to play out. That clearly isn’t going to happen in my opinion, so I would not be surprised to see its full-year growth estimate cut sharply to 2% or 2.25%.

The playbook for tonight is so diverse, but EUR/USD bears will need to see the Fed provide a fairly hawkish statement (relative to expectations), with US and European equities continuing the positive price action seen overnight. Risk appetite, it seems, needs to be increasing if EUR/USD is to sell-off, which plays into the idea that the EUR is the key funding currency in the market. A further escalation in the Greek drama seems inevitable, however the irony it seems is this isn’t actually EUR bearish.


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