The dollar has sold off ahead of the FOMC meeting with risk assets remaining on the front-foot, although the major US indices came off their earlier highs after the S&P 500 hit a new record. It looks like the markets are positioned for a dovish Fed meeting, which means the bigger move could be in the opposite direction of the current trends in case the Fed surprises.
As much as I think the Fed should be starting to prepare the market for asset purchases reduction, I am doubtful it will do so at this particular meeting. The FOMC will likely re-iterate that the labour market slack remains too high, even if the economy is in a better shape than in March and more signs of inflationary pressures are evident. I think the Fed will wait until the June meeting when the FOMC will have the updated economic and inflation forecasts to work with.
Still, there is the potential for a hawkish surprise and that’s why bond yields have started to rise again, with investors also easing the selling pressure on the dollar in case the Fed does catch the market off guard. Fed Chair Jay Powell is likely to acknowledge that economic conditions have improved but will probably stop short of providing any clear hints as to when the Fed will actually taper QE. If he sounds more hawkish than expected, then the markets may see that as a sign that the Fed is getting worried about inflation and that it might decide to withdraw support quicker once it starts the tapering process.
Inflationary pressures on the rise
Indeed, inflationary pressures are building up. We’ve seen big rises in commodity prices such as copper, iron ore and lumber. Prices of soft commodities have also risen sharply with wheat, soybeans, coffee and cotton all pushing higher. Don’t forget that housing costs are on the rise too.
With margins tight, producers will likely pass on these raised input costs onto consumers. So it will be only a matter of time before the CPI overshoots the 2% target and there is a risk that inflation could be more sticky than the Fed expects.
In fact, by keeping the QE taps wide open, the Fed are only fuelling the fire, which will eventually require faster tightening to put out the flames. Against this backdrop, you would have to think that the US equity markets, especially growth stocks whose yields are low, might struggle going forward.
Dollar weakens ahead of the FOMC
If the Fed turns hawkish, the dollar is likely to come back strongly, especially against some weaker currencies – those where inflation is not too much of a concern, such as the Japanese yen and Swiss franc. Otherwise, we could see the Aussie and Kiwi joining the Canadian dollar in hitting new highs against the greenback. The pound and euro also look bullish. From a technical point of view and as things stand, things will only turn bullish for the dollar index if it were to form a higher high above 91.42.
Source: ThinkMarkets and TradingView.com
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