USD: Prelude To A Rate Hike - Credit Agricole

Markets have recently keyed in to event risks related to China’s equity implosion and Greece. We suspect that these risks will continue to fester behind the scenes for quite some time but still we think the immediate attention will shift to the FOMC. The chief concern on most investors’ minds is whether the FOMC will signal today that a September rate hike is coming.

The Fed in our view is unlikely to pre-commit to a September rate hike at today’s meeting. Instead, it is more likely to remain data dependent, noting a cautiously upbeat assessment of progress on its dual mandate. Indeed, its statement will likely reflect the strength of the labour market, indicating the absorption of slack and the tentative signs of wage pressure. We think the tone of the statement will reflect Yellen’s recent speeches. Recall, in her semi-annual testimony to Congress the statement and Q&A suggested that the FOMC remains on track to hike rates this year, introducing a bit of a hawkish tint to her language. She noted that prospects for the economy and labour market are favourable while noting the recent pickup in consumer spending - in spite of the weak June retail sales report.

The Fed chair also played down the concerns from international risks, consistent with the message from other speakers. In addition, recent US data releases remain consistent with a September rate hike. Notably, economic surprises in the US have perked up since mid-Q2. The index has nearly unwound its decline from early 2015 with real estate and consumer sectors leading the recovery from the Q1 blip. Housing has been solid of late, rising steadily throughout 2015. The labour market also remains upbeat with the trend in initial jobless claims and monthly employment gains pointing to diminishing labour market slack. According to Fed estimates NAIRU rests at 5.2%, which suggests the US labour market should soon reach equilibrium. We look for 2.5% growth in Q2, which shows a decent payback from the Q1 blip but more importantly it shows that above-trend growth persists.

Any shift in the FOMC’s statement will likely drive the FX market’s response. The OIS market is pricing in around a 30% chance of a September rate hike while Fed Fund’s futures are pricing in a mere 19% chance. To us, this suggests that, despite the recent rally in the USD TWI (up 4.1% since late June), a cautiously upbeat message from the Fed could help extend the gains. The biggest losers will likely remain commodity currencies and those with large external imbalances.

Alternatively, a more dovish-than-expected statement will likely prompt an extension of the recent position squeeze, providing a boost to the commodity complex in particular. Even so, we think any pullback will be short-lived, especially given that markets still have plenty of data to digests before the September meeting.

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