Fed Breathes New Life into Dollar, Signals Dec Hike

The Federal Reserve has every intention to raise interest rates one more time this year and 3 times in 2018. This unambiguously hawkish monetary policy outlook caught many investors by surprise and sent the dollar soaring against all of major currencies.  EUR/USD fell the most as it traded above 1.20 ahead of the announcement but USD/CHF and USD/JPY also experienced sizeable gains. According to the FOMC statement, the Federal Reserve believed that the hurricanes would not alter the economy's general course because spending is expanding at a moderate rate, investment increased and labor activity strengthened.  While recent economic reports don't show these improvements, we can't diminish the Fed's overwhelmingly positive outlook.  Aside from planning to start balance sheet rolloff in October, 11 Fed officials see one more hike in 2017, 4 more than in June.  In her press conference Fed Chair Janet Yellen said nothing to quell optimism and instead said the recovery is on a strong track.  She also confirmed that while 3rd quarter growth will be held down by the Hurricanes, the economy continues to expand at a moderate pace in coming years. She pointed to the pick up in exports and business investment as areas of strength and said payrolls gains are well above the pace needed to absorb new entrants.  Yellen also felt that the slack in the labor market has largely disappeared with the steady participation rate indicative of a healthy labor market. On inflation she believed the factors holding down price growth should be transitory so gradual rate hikes are still warranted.  At the end of the day USD/JPY shot above 112 because the degree of the Fed's hawkishness was greater than the market anticipated and with the pair breaking the 200-day SMA, further gains are likely. Tonight the Bank of Japan has a monetary policy announcement and no changes are expected. There will be 2 new monetary policy members joining the committee but they are likely to side with the majority at their first meeting.  The announcement should be a non-event for the Japanese Yen, which leaves USD/JPY at the mercy of dollar bulls.

EUR/USD dropped below 1.19 on the back of the FOMC announcement.  The move had nothing to do with the outlook for the Eurozone economy or ECB policy.  Investors completely shrugged off this morning's euro positive comments from ECB member Knot who called for a recalibration of policy in favor of buying U.S. dollars.  Yet Knot's comments should not be ignored as he is confident inflation will return to levels consistent with their goal as the main rationale for ECB asset purchases has vanished. According to Michael Fuchs, a key member of German Chancellor Merkel's party feels that the current euro level is reasonable for both Germany and Italy. Producer prices in Germany also increased with the year over year rate jumping to 2.6% from 2.3% in the month of August. The most important event risk this week will be the Eurozone PMIs but investors will also be watching ECB President Draghi's speech tomorrow closely to see if he mentions the possibility of delaying part of their taper decision to December as Reuters reported on Tuesday. If he does, EUR/USD will extend its losses but if he confirms that major changes are coming in October, EUR/USD could recover.

GBP/USD ended the day only slightly lower but this unchanged performance masks a major intraday reversal. GBP/USD broke above 1.36 on stronger than expected retail sales but settled the day below 1.35. Consumer spending jumped 1% in the month of August, which was significantly stronger than the market's 0.2% forecast.  Spending in July was also revised sharply higher.  This brought the year over year rate to 2.4% from 1.1%.  Excluding auto fuel, spending was just as firm with the same 1% monthly gain.  On an annualized basis retail sales ex autos rose 2.8% from 1.5% the month prior.  This increase was the strongest in 4 months and far exceeded market expectations. These numbers reinforce the Bank of England's recent hawkishness and should pave the way for further outperformance for sterling. Unfortunately between U.S. dollar strength and Friday's Brexit speech GBP was unable to hold onto those gains. In the latest Brexit developments, Britain is apparently planning to offer the EU a EUR 20 billion divorce payment to restart stalled Brexit negotiations after Boris Johnson retracted his threats to resign.  The EU previously wanted 60 billion euros but this offer could be a starting point for negotiations.

Next to the greenback, the best performing currency today was the New Zealand dollar.  A stronger than expected current account balance and reports that the ruling National Party is regaining lead in the upcoming elections helped NZD hold onto its gains and outperform its peers. This weekend's election is still too close to call but clearly the FX market prefers that the current party stay in place.  New Zealand's second quarter GDP numbers are due for release this evening. Although the Reserve Bank has been more cautious than optimistic about the country's outlook, GDP growth is expected to have accelerated in the second quarter thanks to stronger retail sales and trade activity. It is third quarter growth that the RBNZ is worried about.  The Australian dollar also ended the day up thanks to positive comments from RBA Assistant Governor Ellis who said there is still a bit of slack in the Australian labor market (even though its performed well lately) and they are concerned about the Brisbane apartment market which has not seen the same house price growth slowdown as Sydney and Melbourne. The Canadian dollar on the other hand continued to slide despite a nearly 2% rise in oil prices and uptick in Canadian yields.