FOMC interest rate meeting awaited with trepidation

31 January 2017  •  Source: Nordine Naam, Natixis

FOMC interest rate meeting awaited with trepidation by the dollarA stronger dollar

The US dollar extended its correction during last week, especially against commodity currencies and sterling. The dollar’s bout of weakness is linked to a first raft of protectionist measures having been announced by Donald Trump. The President signed an executive order ending US participation in the Trans-Pacific Partnership (TPP) and said he wanted to renegotiate the North American Free Trade Agreement (NAFTA). Finally, he confirmed plans for the construction of a wall along the Mexican border and threatened to introduce a 20% border tax on goods imported from Mexico if the country refuses to pay for the wall’s construction.

All these announcements weighed on the dollar even though it is difficult to predict the effects on the US economy. Will the measures to penalise imports and exports lead to a rise in unemployment and inflation? In short, the effects of these protectionist measures will be rather negative, but over the long term.

Even so, the DXY dollar index failed to pull back below 100. It would seem therefore that announcements by Donald Trump are having slightly less impact on the market than before. On the other hand, the US dollar seems to be reacting increasingly on the upside to the rise in US long interest rates, which are back at their recent highs, with the 10-year at 2.55%. This recovery has been fuelled by the upturn in actual inflation and, especially, in inflation expectations in reaction to the rise in the price of Brent, to the protectionist measures announced recently and to concerns conditions in the labour market and the clampdown on immigration will bring pressures to bear on wages.

In this context, the Federal Reserve (the Fed) has clearly turned more hawkish. In the run-up to the next Federal Open Member Committee (FOMC) meeting, the US dollar will be bolstered by concerns the FOMC’s rhetoric will be more aggressive in reaction to the increasing inflationist pressures. Similarly, the Employment Publication Report scheduled for release this Friday is expected to underscore the solidity of the labour market, in turn fuelling the rise in long interest rates, which will be favourable to the US dollar.

EUR/USD: heading towards 1.034

The weakness of the US dollar enabled the EUR/USD to break above 1.07 before falling back towards 1.06 at the end of last week. It is also true that the latest purchasing manager’s index (PMI) held at high levels, suggesting that Eurozone growth is bearing up. This week, watch out for a raft of European Commission business surveys for January, which should confirm last week’s PMI. Also, Q4 2016 GDP will be published and, especially, the inflation flash estimate for February, with a further increase expected given higher energy prices. Unless there is a major surprise, these publications are unlikely to bring into question the continuation of the European Central Bank’s (ECB) Asset Purchase Programme. At any rate, this will not be enough to spur a rebound by the euro, especially if the US dollar firms. All in all, we still see the EUR/USD pulling back towards 1.034 over the short term, especially since political risks have not dissipated in Italy and in France.

GBP/USD: on course towards 1.235

Sterling extended its rebound, recording the sharpest increase against the US dollar, drawing strength from the improvement in the macroeconomic indicators out of the UK (notably the 0.6% GDP growth in Q4 2016) and the announcement by Theresa May that MPs will be provided with a white paper outlining the government’s Brexit strategy. What’s more, the Supreme Court upheld the ruling of the London High Court to the effect Article 50 cannot be triggered without consulting Parliament. It is likely that this led to the squaring of short sterling positions. Even so, the UK is still heading for a hard Brexit, i.e. is set to lose access to the single market and its passporting rights. Growth is solid right now, but sooner or later the prospect of a hard Brexit will have negative effects on British growth by curbing foreign direct investment and more generally company investments because of the lack of forward visibility. This week, watch out for the Bank of England’s (BoE) Inflation Report, notably to see if inflation forecasts have been revised upwards. For these reasons, we remain negative on the GBP/USD for the short term, with a target at 1.2350.

USD/JPY: heading towards 118

The USD/JPY stabilised over the course of last week despite the greenback having weakened. In fact, the yen rose sharply at the start of last week before correcting at the end of the week in reaction to the upturn in US long interest rates. This caused the spread between US and Japanese 10-year rates to widen, in turn penalising the Japanese currency. With the Japanese 10-year rate nearing 0.08%, this suggests that the Bank of Japan (BoJ) will remain active in the Japanese bond market. Given uncertainties over Trump’s programme, the BoJ is likely to maintain the status quo at this week’s meeting, therefore continue to focus on controlling the 10-year rate so as to keep it around zero percent. We see the USD/JPY heading back towards 118 this week if, as we expect, US long interest rates extend their rise.

USD/CAD: set to recover towards 1.33

The Canadian dollar appreciated on the back of the rise in the price of Brent. Nonetheless, we expect the USD/CAD to rebound given that Bank of Canada (BoC) remains very dovish, which will exacerbate the divergence in monetary policies on either side of the border and, more generally, lead to a further widening of the spread between long rates in both countries. Furthermore, we expect Brent to level off in reaction to the increase in US production. Therefore, we see the USD/CAD recovering towards 1.33 in the very short term and then towards 1.35 over coming months.

EUR/JPY: 123.50 resistance will be crucial

Given that daily volatility is tending to subside considerably, any pullbacks should be limited, a break below the support around 120.90-121 (lower band of daily Bollinger) therefore being unlikely. Rather, keep an eye on the resistance at 123.50 (short term ascending resistance trend line and upper band of daily Bollinger). A breakout above this level would invalidate the short-term downward bias, releasing significant upside potential, opening the way for a recovery towards 125.18 (monthly Bollinger moving average) before 126.34 (upper band of weekly Bollinger).Supports are located at 122.20, around 120.90-121, at 119.50 and at 118.91.

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