Fed’s non-committal forward guidance; We still favour the USD

The Fed delivers a hawkish cut. Central banks’ policies still favour the USD.
Eugene Leow, Philip Wee19 Sep 2019
    Photo credit: AFP Photo

    Rates: Fed’s non-committal forward guidance      
    Overnight, the Fed delivered another 25bps worth of cuts, taking the Fed funds rate upper bound to 2%. Markets were expecting a more dovish take from the Fed and were caught wrong footed, sending yields (especially the shorter-term ones) sharply higher when Powell emphasized that the US economy is on firm footing. Moreover, the Fed appears to be mildly complacent in addressing USD funding concerns and that may have disappointed some bond bulls.

    The takeaway from the FOMC is that further rate cuts may not be as forthcoming. “Insurance cuts” should not amount to more than 2-3 and unless economic numbers tank or a shock hits (worsening of trade tensions), the case for aggressive cuts would not be compelling. The median dot plot for end-2019 and end-2020 now stand at 1.875% (no more cuts). However, this figure masks the sizable dispersion in views on where policy rates should be heading in the coming quarters. On balance, we suspect that market will maintain a dovish bias noting that external risks (global growth, trade war and hard Brexit) are still lingering. However, a bottom in USD rates (longer-term swaps and yields) have likely already been traced in late August / early September.

    The Fed addressed the USD funding squeeze but did not offer details on a more permanent solution. The IOER was reduced by 30bps (5bps more than the Fed funds rate), but this is a token move compared to the swings seen in overnight rates. At this juncture, the Fed appears to be prepared to utilize ad-hoc repo operations a lot more frequently (Thursday will mark the third consecutive day) to handle liquidity stresses. To be sure, the Fed hinted that balance sheet expansion will likely take place sooner rather than later. Further details may be available in October. If announced, the amount would likely be small (USD 10bn/mth) and should not be misconstrued as quantitative easing. We suspect that a standing repo facility is still the best way to cap unwanted spikes in overnight funding costs.

    FX: Don’t fight the Fed and ECB

    The monetary policy stances of central banks in Developed Markets have returned in favour of the US dollar. Barring further shocks to the global economy, the Fed’s economic projections and guidance suggested that it was likely done with its mid-cycle adjustment. The Fed’s most dovish counterpart is the European Central Bank who is set to resume its (open-ended) asset purchases programme in November. The Bank of England likely to signal a “dovish hold” at today’s meeting, now that UK inflation has fallen below its 2% target. The Bank of Japan, which also meets today, is seen moving towards a “flexible hold”.

    To be sure, the Fed’s two “hawkish cuts” did not take down the US dollar this year, just as its three “dovish cuts” failed to lift the greenback in 2017. The relative growth outlook, especially the one between the US and the Eurozone, matters greatly to the USD Index (DXY) for one simple reason. The euro accounts for a whopping 57.6% of the weight in the DXY index. The Fed had kept its 2019-2020 growth forecasts firm and at/above 2% while the ECB’s growth projections have edged closer to 1% from 1.5%. As for inflation, the Fed expects a pick up to 1.9% in 2020 from 1.5% this year. Conversely, the ECB expects inflation to decelerate to 1% from 1.2%. We still see EURUSD headed into a lower 1.05-1.10 range and the DXY appreciating to its psychological 100 level.

    Eugene Leow

    Rates Strategist - G3 & Asia

    Philip Wee

    FX Strategist - G3 & Asia

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