USD: FOMC credibility a threat of US dollar performance

The long-end of the US Treasury bond market sold off last night taking the US dollar weaker as well as Fed Chair Warsh spoke in detail for around 45mins but without providing any clear explanation as to why the FOMC decided to keep the key policy rate unchanged. The markets were impressed with Chair Warsh after his first press conference in June, confident that the Fed would tackle inflation remaining above target. He spoke similarly tough last night but implied that the financial markets were moving in the direction required based on market information rather than Fed rhetoric.

Warsh was asked numerous times to provide an explanation for not acting at this meeting and failed to provide an answer beyond the fact that there had been rigorous debate and that the FOMC was united in its commitment to achieve price stability. Three FOMC members dissented underlining the likely rigorous debate (“family fight”) that took place. The 2s10s curve steepened 10bps in response with the 5y5y inflation swap rate jumping 6bps since the meeting. We see three explanations here : 1) This potential more laissez-faire approach from Warsh means a less active Fed that will therefore, increase risks of the Fed ending up behind the curve. This will add to the term premium and steepen the yield curve; 2) Warsh mentioned that part of yesterday’s discussion related to assessing the degree of stimulus coming from the balance sheet. If this is being debated now investors will likely need to incorporate a bigger risk of a sooner adjustment in the size of the balance sheet; and 3) Is Warsh is more ideologically opposed to rate hikes than previously assumed? The bond market sell-off undoubtedly wasn’t helped by President Trump’s comment as the press conference ended that “Warsh would love to see lower rates”. Political influence and a divided FOMC between the Board of Governors and the Presidents will concerns investors.

The 2s10s spread has had its biggest jump since August last year and we would argue the outcome of the Fed meeting is certainly US dollar negative. The drop for the US dollar has been modest though in part on the belief that rate hikes are still coming. Pricing for a hike in September did drop but a hike in October is fully priced. There has also been a further escalation in the conflict in the Middle East and crude oil prices are drifting higher – another development that raises the prospect of a hike.

The outlook ahead though is now less clear with greater uncertainty over the reaction function of the Federal Reserve. That’s not a positive development for the dollar and risks are skewed toward further curve steepening that tends to coincide with dollar depreciation. Fed credibility is being questioned today and after a big jump in inflation expectations the US dollar outlook has certainly worsened.

US YIELD CURVE STEEPENS WEIGHING ON USD

Source: Bloomberg, Macrobond & MUFG Research

GBP: On hold once again but inflation risks in focus

The pound remains the top performing G10 currency after the US dollar since the conflict in the Middle East began at the end of February and following the FOMC decision last night, the focus shifts today to the BoE policy decision. We published a preview of the meeting on Tuesday (here) and continue to expect the BoE to remain on hold at this meeting and going forward. There is nothing priced for today and hence the issue for the markets will be the vote, the communication in the statement, the minutes and the updated forecasts in the Monetary Policy Report. So there’s a lot of information to get through but ultimately the take-away is likely to be that the MPC remains somewhat divided with some concerned over inflation pass-through from energy and others less concerned given the relatively weak domestic economic conditions. A September hike is priced at a little over 50% while a hike is fully priced by November, so the rates market is more priced for some signs of increased concerns shifting the MPC toward a hike.

For market rates to move higher and the pound to advance in response to today’s meeting we will need to see increased conviction on a September rate hike. We expect the multi-scenario approach to be abandoned with a return to a single set of forecasts but accompanied with some risks. The backdrop today remains difficult with crude oil and natural gas prices rebounding significantly and the US signalling further escalation. The energy backdrop therefore is worsening but the inflation backdrop given recent CPI releases is better. Inflation is set to pick up which will be evident in the forecasts but if inflation is forecast to fall back to target by Q1 2028 then the take-away is likely to be that there is time to assess the inflation risks, and pricing for a September rate hike could ease back somewhat, taking the pound lower.

However, the reality of the geopolitical situation suggests the communications will likely convey a level of increased concern. A conflict that drags on (even say with energy price rises that are less than previously feared) appears a greater risk today than at the June meeting and a more prolonged energy price rise could certainly force the BoE to act, even in circumstances of mixed labour market conditions.

Energy price moves therefore suggest upside risks to yields on evidence of increased concerns amongst MPC members. However, with a hike in September now priced at 60% we don’t envisage any sharp move higher in yields today, especially after the notable move higher in Gilt yields yesterday. We expect the pound to remain well supported at these levels on the assumption that pricing for a September rate hike holds up given the rising external inflation risks. Remarkably low levels of FX volatility also continues to provide support for the pound.

LOW FX VOLATILITY, FAVOURABLE MARKET CONDITIONS SUPPORT GBP

Source: Bloomberg & MUFG Research