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Investors are girding their loins ahead of tomorrow’s US Federal Reserve rate decision. According to the Federal Funds futures market there is no likelihood of another rate hike to follow on from December’s move. However, there is a feeling that the Federal Open Market Committee (FOMC) will deliver a hawkish statement and talk up the probability of a rate rise at its June meeting. This may or may not lead to a rally in the US dollar. Given how the yen and euro reacted to recent monetary policy adjustments from the Bank of Japan (BOJ) and European Central Bank, nothing can be certain. At the end of January the BOJ took interest rates into negative territory. This was completely unexpected. Little more than a week previously BOJ Governor Haruhiko Kuroda had assured the Japanese parliament that he wasn’t considering negative interest rates. Yet despite making a move designed to undermine the attraction of the Japanese yen, the BOJ was caught off-guard when the currency rallied sharply following their decision. It is safe to assume that this wasn’t the reaction it was hoping for. There was some confirmation of this last night when the BOJ delivered its latest rate statement. It removed the passage from January saying that it would cut interest rates further into negative territory if judged necessary. BOJ member Takahide Kiuchi said that negative rates impair the function of financial markets.

As far as last week’s ECB meeting is concerned, the central bank took its deposit rate deeper into negative territory. But it offset the damaging effects of margin compression on banks by implementing a system that would reward them for increased lending outside the central banking system. Despite this, together with a trolley-load of stimulus measures, the euro (like the yen) defied expectations and rallied strongly. Investors inferred that the ECB had reached the limits when it came to easing monetary policy. Even if more was forthcoming, the effects would now be severely diminished.

So now we have the Fed. Back in December when the central bank raised rates for the first time since June 2006, the FOMC projected an additional 100 basis-points of hikes for 2016. The dollar rallied as investors repositioned themselves for the widening divergence in monetary policy between the Fed and the rest of the developed world central banks. But the greenback fell sharply in early February as market turbulence, the ongoing sell-off in oil and concerns over high yield bonds led to a big risk-off move. Investors became convinced that the FOMC would have to dial back on its plan for tighter monetary policy. There was even plenty of speculation (including from me) that the Fed’s next move would be a reversal of its December hike rather than further tightening.

We’ve had a big rally in risk assets since Janet Yellen delivered her testimony in Washington on 11th February. She managed to convince everyone that the US economy was steaming along at a decent clip, but there were sufficient global concerns for the central bank to be restrained when it came to tightening monetary policy. The FOMC will want to keep the upside momentum going, so expect something similar from its statement and summary of economic projections tomorrow.

However, it may prove harder to keep things going this time round. The bounce-back in oil and equities looks to be losing momentum. This could just be consolidation and tomorrow could provide the impetus for another leg higher. But the dollar is the key to where we go next and I can’t help thinking that it may surprise us. Conventional wisdom says that the dollar should strengthen as the Fed looks to tighten as other central banks continue with loose monetary policies. But this seems an obvious trade and one which is probably priced in to a large extent. If the dollar were to weaken now then it would take a lot of pressure off oil, other dollar-denominated commodities and emerging markets with dollar-denominated debt. It would also help the sales and earnings of US multinationals. Of course, the markets will do whatever they do. But no one is ready yet for an all-out currency war and January’s G20 meeting could have provided a venue for discussing a coordinated approach to future FX moves. After all, the BOJ Governor appears to have changed his mind on negative interest rates after meeting up with G20 colleagues. Who knows what else was discussed?

Disclaimer:

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

 

Posted by David Morrison

Tagged: Bulletin PM

Category: PM Bulletin


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