Dollar fights back ahead of the FOMC decision

Yesterday, the dollar found its composure after a poor performance on Monday. A better global risk sentiment put a floor for the US currency going into the FOMC meeting. Slightly higher US inflation data gave the dollar additional interest rate support. EUR/USD closed the session at 1.0931 (from 1.0992). USD/JPY regained the 121-mark and closed the day 121.79 (from 121.03).

Overnight, Asian equities are trading with strong gains, following a decent session at Wall Street, Japan outperforming on the back of a weakening yen. The Nikkei manufacturing PMI for Japan stabilized at 52.5 in December. Commodities are going a bit higher, but not enough to call it a turnaround (except for oil that is slightly lower). US high yield bond troubles are shifting to the background following a rout in previous days. The trade weighted dollar is little changed as is EUR/USD (1.0940), while USD/JPY is modestly higher (121.90). US Congress apparently agreed a fiscal plan avoiding a potential government shutdown and lifted the restriction of a 40-year ban on oil exports. So, the mood is positive going into the FOMC meeting.

FOMC meeting: the long awaited lift-off. What’s next?

Besides the FOMC, the European PMI’s are interesting too. The FOMC rate decision for the Upper Bound is expected to increase from 0.25% to 0.50%. We expect the mean dots to be lowered by a one 25 bps rate hike in both 2016 (3 instead of 4) and 2017 (4 instead of 5), with a possibility, but big question mark, for a lowering of the long run neutral Fed fund to 3.25% (from 3.5%). This (especially if the long run neutral rate would be lowered) would support the gradual message that is expected from Yellen. (see below for dollar reaction). In the eurozone, the December Markit manufacturing PMI is expected to remain stable at 52.8, but the Markit services PMI is expected to decline marginally from 54.2 to 54.0. We see side with the consensus.

Of late, the US currency dropped below important support against the euro and the yen. At the end of last week and early this week, the dollar showed tentative signs of a bottoming out process, including the rebound yesterday. Today, the data (see above) won’t trigger a directional USD move just hours before the key Fed-policy decision. The Fed is largely expected to raise the target range for its policy rate by 25 basis points. This would be the de facto start of real policy divergence between the Fed and the ECB (and other central bankers). Of course, a lot of expected divergence is already discounted in interest rate differentials and in FX markets. At the same time, the Fed will reiterate that policy normalisation will be very gradual.
The Fed dots will be important for market expectations on the pace of further Fed tightening. If the dots indicate aggregate Fed expectations for 3 addition rate hikes in 2016, this might be neutral to slightly positive for the dollar, especially in case of a constructive stock market reaction. Dots implying 4 expected rate hikes might further widen the interest rate differential between the dollar and the likes of the euro. In theory this would be a positive for the dollar too, but in that scenario the reaction on other markets (equities, oil..) might be less constructive. So plenty of other scenarios are possible. One should be really brave to front-run this FOMC decision. In a longer term perspective, we maintain the view that policy divergence has probably still a role to play. Admittedly, this shouldn’t affect the immediate reaction to the FOMC decision.

From a technical point of view, EUR/USD cleared 1.0979 resistance, making the picture again neutral . A previous range bottom/break down area comes in at 1.1087 and finally the October high at 1.1124. These are tough resistance levels. If broken it would make the picture dollar bearish. This is not our preferred scenario, but the performance of the dollar was not really convincing of late. A sustained decline below 1.08 would improve the technical dollar picture. USD/JPY dropped below a short-term range bottom in the 122.25 area, turning the short-term picture in this cross rate negative as well. A sustained improvement in risk sentiment is needed to halt this decline.

Sterling profits from better global sentiment

Today, the labour market data are for release. Recently, sentiment on sterling was rather negative. The labour market report is in this respect another hurdle. Especially the expected decline in wages, if confirmed, might weigh on sterling. Another item that is currently becoming into focus is the potential Brexit, with great concerns out of Germany and a poll that put chances on Brexit even.

So, for now we remain cautious on sterling and the test of the 0.73 may go on and in case of weaker labour data. For the FOMC meeting, we are neutral for EUR/GBP, but cable may be under pressure. We first want to see real sterling strength before becoming sterling positive again. A sustained drop below 0.72 would be a positive. Technically longer term, the pair is still in a broad sideways range with boundaries between 0.6938 and 0.7483.

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