USD on the backfoot, data-dependent Fed needs some confirmation to act

Outlook:

The sense of antagonism in Greece-eurogroup talks was reduced considerably by the demotion of Varoufakis, but he’s still the Finance Minister and some analysts say he can still stick his snout into the talks and be generally disruptive. Stay tuned—but the heat surrounding default and Grexit is only lukewarm now.

We don’t know if it was Greece that provided support to the euro, but note that both Japan and the UK offered up bad data this morning and those currencies did not drop. Sterling initially fell but recovered. This tells us that it’s the dollar that is on the defensive. Today we get the Feb Case-Shiller 20-city home price index, forecast up a decent 4.8% (after 4.6% in Jan). We also get the Conference Board April consumer confidence index, also expected better at 102.4 from 101.3.

But the biggie is the Fed policy meeting that starts today and ends with the Statement tomorrow. A Bloomberg survey shows 73% of 59 economists see the First Rate Hike in September, from 37% in the March survey. Before the Fed statement, we get Q1 GDP, generally forecast up a mere 1% q/q when Q4 was 2.2%.

Again the press is noting that inflation expectations are on the rise. The FT writes that the 10-year break-even has jumped from a low of 1.53% in mid-Jan to 1.92% yesterday. The 5-year break-even rate has risen to 1.71%, the highest since September, and the 2-year is the highest since July 2014.

“Several widely-watched gauges of US inflation expectations have climbed to their highest levels this year, as oil prices regain their footing and some investors bet that the Federal Reserve will be slow in quelling any price pressures…. Ahead of the US central bank meeting on Wednesday, daily deposits into global inflation-protected bond funds monitored by EPFR Global indicate that inflows have hit a weekly record, with US funds dominating investor interest. Up until April 22, roughly $1.4bn has gushed into US inflation-protected bond funds — more than the previous three months of daily flows combined.” And the bond gang is asleep at the switch. One analyst told the FT “bond markets — currently trading at record low yields — are unprepared for even the risk of somewhat less subdued inflation, which could spur the Federal Reserve to become less dovish.” Market News reports that major names are, indeed, complacent. RBS thinks the tone of the FOMC statement will be cautious. The Q1 slowdown has “diminished expectations for the year 2015 as a whole.”

Economists at BNP feel the same. The Fed won’t rule out June but will express so much uncertainty about the outlook that the Fed fund futures—4% probability of a June hike—will be proved right. And UBS analysts "see the FOMC at a standstill, held in place by softer growth figures. The result is likely to be little change in the FOMC statement." Deutsche Bank also sees no substantive change and forecasts the 2% inflation targets will cause normalization—by year-end.

Presumably the Fed already has the Q1 GDP, expected at around 1% (Market News has a forecast range of 0.9% to 1.5%). While markets may be impressed by GDP, it’s backward looking and by now we should all have a sense of seasonal cyclicality, not to mention one-time but big externalities (weather, strike). We doubt the Fed gives a hoot about GDP.

It’s more likely to care about (1) the true trajectory of inflation, with core CPI already at 1.8% and (2) not making a mistake. NY Fed Dudley made one of the best comments yet—how the market responds to the first rate hike goes a long way in determining how the Fed behaves afterwards. We would like to see the Fed shake up the bond gang a little and inject a little fear. The 10-year yield has not been able to hold over 2% for long when the year-end quote was 2.17%. Maybe the Fed has been slow to goose the fixed income market because it genuinely fears the strong dollar effect on inflation, and higher yields can only draw in more foreign money--a vicious circle.

Whatever the Fed’s thinking, the dollar is on the backfoot and will remain defensive unless and until data is so wonderful that traders can’t put off adding a bigger position. Before that time, we are in the same-old, same-old stance of every little downward data twitch harming the dollar disproportionately and every little good sign from Europe benefitting the euro disproportionately. It ain’t fair but it’s the way things work.