Dollar Remains Under Pressure Ahead of FOMC Decision

September 18, 2024

Win Thin

This is one of the most uncertain Fed outcomes in recent memory; Chair Powell’s post-decision press conference could generate plenty of fireworks; August retail sales were solid and growth remains robust in Q3; BOC releases its summary of deliberations even as disinflation continues; Brazil is expected to hike rates 25 bp to 10.75%
U.K. reported mixed August CPI data; South Africa reported soft August CPI data
Japan’s government maintained its view that the economy is recovering at a moderate pace; Japan reported soft August trade and solid July core machine orders; New Zealand reported Q2 current account; Indonesia delivered a dovish surprise and cut rates 25 bp to 6.0%

The dollar remains soft ahead of the FOMC decision. DXY is trading lower near 100.708 as the market sets up for a jumbo 50 bp cut (see below). The yen is outperforming despite mixed data (see below), with USD/JPY trading lower near 141.60. The euro is trading higher near $1.1135, while sterling is trading higher near $1.3220 as CPI data support a cautious BOE easing path (see below). The U.S. data remain firm (see below) and so we continue to believe that market expectations for aggressive Fed easing remain overdone. Yet we cannot stand in the way of this fast-moving freight train and so until market pricing changes, the dollar is likely to remain under pressure. While we acknowledge heightened risks of a dovish surprise from the Fed today (see below), we believe it is unlikely that the Fed will validate market pricing for 250 bp of easing over the next 12 months. If so, the dollar could get some traction.

AMERICAS

The two-day FOMC meeting ends this afternoon with a decision. Consensus expects a 25 bp cut. However, a handful of analysts look for a larger 50 bp cut, while the market is pricing in nearly 70% odds of such a move, up from 10% last week right after the PPI data. We favor a 25 bp cut but acknowledge real risks of 50 bp. The vote for the monetary policy action will be worth monitoring and the last time there was a dissent at the FOMC was at the June 2022 meeting. It’s worth noting that the Timiraos article suggested Powell’s colleagues were surprised by his dovish tone at Jackson Hole.

We note that this is one of the most uncertain Fed outcomes in recent memory. The Fed has for the most part managed market expectations quite well during the tightening cycle. Up until last Friday, it seemed to have done the same for the start of the easing cycle as markets had all but conceded a 25 bp cut. However, the WSJ article by Timiraos threw a spanner in the works and now markets are left with a greater sense of uncertainty regarding today’s decision. Whatever it is, we suspect market reaction will be very volatile.

The new Dot Plots will be very important. We will clearly see a dovish shift in the Dot Plots. However, we do not think the Fed will validate the current market pricing for nearly 250 bp of easing over the next 12 months. Recall that the June Dots saw one cut in 2024 vs. three in March, four cuts in 2025 vs. three in March, and four cuts in 2026 vs. three in March. Both March and June showed nine 25 bp cuts in all through 2026. Our base case is that the 2026 and longer-term Dots will remain unchanged today and so the big question is how front-loaded the Fed thinks it needs to be.

We see three likely scenarios. 1) Hawkish: 25 bp cut and the Dot Plots still indicating nine 25 bp cuts through 2026 (same as the Fed’s March and June Dot Plots). In this scenario, a relief rally in USD would likely unfold, underpinned by an upward adjustment to U.S. interest rate expectations; 2) Moderately dovish: 50 bp cut and the Dot Plots still indicating nine 25 bp cuts through 2026, but with most of the easing front-loaded in 2024 and 2025. In this scenario, USD has a kneejerk downside reaction as a jumbo rate cut is not fully priced in, but USD downside is limited because the Fed signals its easing cycle will remain more modest than market pricing; and 3) Very dovish: 50 bp cut and the Dot Plot plots indicating ten (or more) 25 bp cuts through 2026, with most of the easing front-loaded in 2024 and 2025. In this scenario, USD would come under further broad-based downside pressure on falling rate expectations, narrowing yield spreads, and improving financial market risk appetite.

We lean towards the first scenario because the U.S. macro backdrop is in a good place. Economic growth remains robust and driven by strong consumption, the progress on inflation is encouraging, and a soft-landing in the labor market is underway. However, we acknowledge that the risks are heavily skewed towards the dovish scenarios, as the Fed may want to insure against a more pronounced labor market slowdown.

Macro forecasts will also be updated. We anticipate the FOMC to make modest tweaks to its macroeconomic projections in order to support its decision and Dot Plots. The 2024 growth forecast will likely be lifted one tick to 2.2%, in line with forward-looking indicators, while the 2024 unemployment forecast will likely be raised two ticks to 4.2% and PCE inflation forecast should be adjusted one tick lower to 2.5%, reflecting recent data.

As always, Chair Powell’s post-decision press conference could generate plenty of fireworks. The base case is for Powell to stick to previous guidance that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” However, the risk of a dovish curve ball is high, as always, as Powell remains focused on the cooling in labor market conditions.
The dollar tends to weaken on FOMC decision days. It has done so for six straight, 13 of the past 15, and 17 of the past 20. Think about that last one. This 20 meeting streak began with the March 2022 FOMC meeting, when the Fed first started its aggressive tightening cycle.

August retail sales were solid. Headline came in at -0.2% m/m vs. 1.0% in July, while ex-autos is expected at 0.2% m/m vs. 0.4% in July. Expectations for a weak headline reading are driven by a soft vehicle sales data already reported. The so-called control group used for GDP calculations is expected at 0.3% m/m, same as July. In y/y terms, headline sales rose 2.1% vs. 2.9% in July, ex-autos rose 2.3% vs. 3.1% in July, and control group rose 3.9% vs. 3.6.% in July. Overall, the data give us confidence that Q3 consumption and GDP growth are holding up well and should carry over into Q4.

In that regard, growth remains robust in Q3. The Atlanta Fed’s GDPNow model is now tracking Q3 growth at 3.0% SAAR vs. 2.5% previously and will be updated today after the data. Elsewhere, the New York Fed’s Nowcast model is tracking Q3 growth at 2.6% SAAR and Q4 growth at 2.2% SAAR. Both estimates will be updated Friday.

Housing market data will also be of interest. August building permits (1.0% m/m expected) and housing starts (6.5% m/m expected) will be reported. Yesterday, NAHB housing market index for September came in as expected at 41 after slipping in August for the fourth straight month to 39, its lowest point of the year. August existing home sales will be reported tomorrow and are expected at -1.3% m/m vs. 1.3% in July. With mortgage rates falling and likely to continue falling during the Fed easing cycle, the housing sector should improve in the coming months.

Bank of Canada releases its summary of deliberations. At the September 4 meeting, the bank cut rates 25 bp as expected for a third straight time to 4.25%. Governor Macklem pushed back against market pricing for a larger cut by noting “there was a strong consensus for a 25 bp cut.” Importantly, the BOC signaled again that more easing was in the pipeline and reiterated “If inflation continues to ease broadly in line with our July forecast, it is reasonable to expect further cuts in our policy rate.”

Meanwhile, disinflation continues. August CPI data yesterday had headline came in a tick lower than expected at 2.0% y/y vs. 2.5% in July, while core median came in a ticker higher than expected at 2.3% y/y vs. 2.4% in July and core trim came in a tick lower than expected at 2.4% y/y vs. 2.7% in July. Headline was the lowest since February 2021 and back at the 2% target. BOC Senior Deputy Governor Rogers cautioned that while inflation slowing to 2% is good news, “there’s still work to do.” However, with both headline and core inflation tracking below the BOC’s Q3 projections (2.3% and 2.5%, respectively), an outsized 50 bp cut at the upcoming October 23 meeting cannot be ruled out. The swaps market price-in about 50% odds of that outcome.

Brazil COPOM is expected to hike rates 25 bp to 10.75%. At the last meeting July 31, the bank sounded hawkish but did not seem to tip the start of a tightening cycle. Since then, IPCA inflation hit the top of the 1.5-4.5% target band in July before edging slightly lower, while the budget numbers have come in worse than anticipated. The swaps market is pricing in 100 bp of tightening by year-end and 175-200 bp of total tightening over the next 12 months.

EUROPE/MIDDLE EAST/AFRICA

U.K. reported mixed August CPI data. Headline remained steady at 2.2% y/y, core picked up three ticks to 3.6% y/y, and CPIH remained steady at 3.1% y/y. Services inflation picked up four ticks to 5.6% y/y. All readings were as expected, but the acceleration in both core and services reinforces the case for a cautious BOE easing path. Indeed, the odds of a cut tomorrow have fallen to only 15%, with the market looking ahead to the November 7 meeting for the next cut.

South Africa reported soft August CPI data. Headline came in a tick lower than expected at 4.4% y/y vs. 4.6% in July, while core came in a tick lower than expected at 4.1% y/y vs. 4.3% in July. Headline was the lowest since April 2021 and below the center of the 3-6% target range. South African Reserve Bank meets tomorrow and the data should cement a 25 bp cut to 8.0%. Of note, the market is pricing in 25 bp of easing over the next three months and 125 bp of total easing over the next 12 months.

ASIA

Japan’s government maintained its view that economy is recovering at a moderate pace. The Cabinet Office released its monthly economic report for September. Last month, it raised its view of the economy for the first time in 15 months. Two nuggets worth highlighting: 1) its assessment of goods prices was revised as “the tempo of increase has slowed in recent days” and 2) it adopted a more cautious stance on the European economy, indicating that it is experiencing a “partial pause.” Both argue for continued caution at the Bank of Japan as it meets tomorrow and Friday.

Japan reported soft August trade data. Exports came in at 5.6% y/y vs. 10.6% expected and 10.2% in July, while imports came in at 2.3% y/y vs. 15.0% expected and 16.6% in July. While the typhoon likely had an impact, the data are nevertheless concerning as weak exports suggest external demand is weakening while weak imports suggest domestic demand is weakening. Of note, exports to the U.S. fell for the first time in almost three years at -0.7% y/y, exports to Europe fell -8.1% y/y, and exports to China rose 5.2% y/y.

Japan also reported July core machine orders. Orders came in at 8.7% y/y vs. 2.5% expected and -1.7% in June. However, there are downside risks ahead as machine tool orders came in at -3.5% y/y in August.

New Zealand reported Q2 current account data. The deficit came in at -6.7% of GDP vs. -6.5% expected and a revised -6.7% (was -6.8%) in Q1. While down from a low of -9.4% of GDP in Q4 2022, the deficit remains large by historical standards, suggesting NZD needs to keep trading at a discount to fundamental equilibrium to attract foreign investments and finance this deficit. We estimate long-term fundamental equilibrium for NZD/USD at 0.6610.

Bank Indonesia delivered a dovish surprise and cut rates 25 bp to 6.0%. No change was expected, but nearly a quarter of the 25 analysts polled by Bloomberg saw a 25 bp cut. Governor Warjiyo said that “The time is right” and added that “Going forward, Bank Indonesia will continue to keep an eye on the room for lowering policy rate in line with low inflation forecast, the stable and appreciating rupiah, and the need to boost economic growth higher.” We think the strong rupiah was a big factor and if it remains strong, BI will continue cutting rates cautiously.

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