Fed’s dovish policy update consistent with outlook for weaker USD

USD: Relief rally after FOMC meeting is unlikely to be sustained

The US dollar has staged a relief rally overnight after hitting a fresh year to date low yesterday at 96.218. It has helped to lift the dollar index back above the 97.000-level. The mixed messages from the Fed’s latest policy update overnight has triggered a pick-up in FX market volatility in the near-term. The US dollar initially weakened following last night’s FOMC meeting when the Fed resumed rate cuts by delivering a 25bps cut and the updated dot plot signalled that the median projection amongst FOMC participants was to deliver two further 25bps cuts by the end of this year. However, the voting pattern did reveal FOMC participants are deeply divided over plans for further easing. While 10 FOMC participants believe that the Fed should deliver 50bps or more of further easing this year, another 9 believe the Fed should deliver less than 50bps of easing by year end. At the extremes one participant believed that the Fed should have left rates on hold this year while at the other end of the spectrum one participant believed that the Fed should cut rates by 150bps. The most dovish dot was likely new Governor Stephen Miran who was the only FOMC participant to dissent against last night’s decision to lower rates by 25bps. He wanted the Fed to deliver a larger 50bps rate cut. The Fed’s decision to resume rate cuts was justified in the policy statement by the acknowledgement that “job gains have slowed, and the unemployment rate has edged up but remains low”. The Fed reiterated that it now “judges that downside risks to employment have risen”. The updated forward guidance stated “in considering additional adjustments to the target range for the federal funds rate, the committee will carefully assess incoming data, the evolving outlook, and the balance of risks”.

The US dollar quickly reversed those initial losses after Fed Chair Powell’s press conference. In the press conference he stated that policy is “not on a pre-set course” and indicated that market participants “can think of today’s move as a risk-management cut”. He added that the Fed is in a “meeting-by-meeting situation”. The reference to a “risk management” cut may have prompted some market participants to think that it could be more of a one-off cut rather than the start of a series of rate cuts. However, we believe the reference to “risk management” cut may indicate that the Fed is being forward looking when deciding to lower rates given the risk that the US labour market may weaken further going forward. If “meaningful” downside risks to the US labour market persist then the Fed will deliver further rates cuts as we and other FOMC participants expect. On inflation, Fed Chair Powell stated that tariff passthrough has been slower and smaller than expected so far. When asked about whether the Fed had considered delivering a larger 50bps cut, Fed Chair Powell stated that there was not widespread support for such a move.

Overall, the Fed delivered a dovish policy update but it was never likely to fully endorse the scale of rate cuts already priced into the US rate curve. The US rate market is continuing to almost fully price in another 50bps of Fed cuts by year end and between 100 and 125bps in total by the end of next year. It compares to the Fed’s median projections for 50bps and 75bps respectively. The 2-year US Treasury yield is currently trading close to levels prior to last night’s FOMC meeting indicating that rate cut expectations over the coming years have not changed much with market participants still expecting the Fed to be more active in lowering rates in response to further labour market weakness and the growing risk of President Trump having more influence over Fed policy next year when Fed Chair Powell is replaced. As a result, we doubt that the relief rally for the US dollar will be sustained.

USD SHORTS HAVE BEEN SCALED BACK SINCE PEAK IN JULY

Source: Bloomberg, Macrobond & MUFG GMR

AUD/NZD: Weak activity & labour market data trigger underperformance

The biggest movers amongst G10 currencies overnight have been the Australian and New Zealand dollars. The main trigger has been the release of the weaker economic activity and labour market data from the region. The New Zealand dollar has declined sharply by just over 1% against the US dollar resulting in NZD/USD falling back below the 0.5900-level. The sell-off for the kiwi was driven by the release of the latest GDP report from New Zealand revealing the economy contracted more sharply than expected by -0.9% in Q2 following on from the +0.9% expansion in Q1. The RBNZ had been forecasting growth of -0.3% for Q2. Weakness in business investment and exports more than offset a modest increase in household spending. The report has encouraged expectations that the RBNZ will continue to lower rates in October and November. There are currently just over 50bps of easing priced in by year end. The RBNZ was already concerned by the ongoing weakening in the labour market where the unemployment rose to a new cyclical high of 5.2% in Q2.

The New Zealand dollar has clearly underperformed so far in Q3 when it has been the worst performing G10 currency. The performance of the kiwi and Aussie have diverged. Over the same period the Aussie has been one of the top three performing currencies. AUD/USD recently broke above resistance at the 0.6600-level although suffered a setback overnight. Employment unexpectedly contracted in Australia by -5.4k in August reinforcing expectations for the RBA to lower rates further in November.

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com