Fed in focus, US10sY pressured, US dollar vunerable but could be thrown a bone

The dollar was little changed on Wednesday with the DXY trading flat in a consolidation of the three consecutive weeks of recovery gains as traders awaited the conclusion of a US Federal Reserve meeting.

Investors will be looking for any sign of response from central bank policymakers to the jump in US inflation. However, the bond market is pricing for a dovish outcome with the 10-year Treasury yield bumping along the bottom of the recent ranges and daily lows.

At the time of writing, the yield is down some 0.6% at 1.4850%. It has dropped from a high of 1.5040% and printed a low of 1.4820% so far. 

However, the retreat in US Treasury yields since the 5th April highs seems at odds with the US economy’s fundamentals, and analysts are doubting whether this can be sustained.

''Our forecast that the 10-year yield will end 2021 well above its current level informs our view that US equities will fail to make further gains this year,'' analysts at Capital Economics said in a note by Oliver Aleen today. 

''The roughly 15bp fall in the 10-year US Treasury yield since 17th May – which has been driven entirely by a drop back in inflation compensation – is hard to rationalise.''

''During much of the pandemic, inflation compensation in the US typically rose in line with equities amid growing optimism about the economy. However, the decline in yields more recently does not appear to be due to investors taking a dimmer view of the economy,'' he explained.

''The fall in inflation compensation also seems strange given the economic data released in recent weeks. May’s consumer prices figures showed that core inflation accelerated by more than expected, to a 28-year high. Meanwhile, the ISM Manufacturing survey also indicated building price pressures, and labour market data pointed to difficulties in hiring, as well as some signs of stronger wage growth.''

All eyes on the Fed

The performance of the bond and stock markets, yields and the US dollar for the summer months will all depend on today's Fed meeting and what signals, if any, the Fed will give on how the central bank could begin unwinding its massive bond-buying program.

It will be of little surprise, however, if the Fed chairman Jerome Powell does not provide the markets much beyond the acknowledgement that policymakers are "talking about talking about tapering."

However, there could be clues in the "dot plot," which is an indication of when policymakers expect interest rate hikes.

Powell has warned markets not to rely too heavily on the dot plot as it is by no means an exact path of policy settings for the future. 

Nevertheless, if there are significant changes, the markets will likely jump on it. Especially given the volatility lull of late. 

Forex has been extremely quiet as seen in the following US dollar volatility chart:

If there is going to be a pick up in volatility and US yields, traders will want to see prospects of the first-rate hike pulled in to 2023 in the median projection. Additionally, some individual dots might also be higher for 2022 and 2023.

It is not all about the dots

Economic forecasts will also be critical. Any significant changes to the Fed's unemployment and inflation outlook could also be a key catalyst. Traders will want to see the Fed acknowledge the recent jump in inflation and robust data as a potential risk to their previous predictions that inflationary forces will not be permanent. 

If policymakers stick to their belief that these are only transitory, and if they lower core inflation forecasts for 2022,  then that could be game over for the US dollar and yields for the foreseeable future. 

The carry trade will most likely weigh on the greenback and support emerging markets, commodities and high beta currencies such as the Aussie dollar that has been closely correlated to the US stock market performance.

AUD/USD / S&P500 weekly chart

On the other hand, if tapering is being more than just talked about, then firmer guidance on it could lead to some ongoing support to the greenback over the course of the summer and weigh on US equities. 

US dollar vs SP500 weekly chart