The Fed left rates unchanged and eventually, the dollar is falling, with a nice swing up in EUR/USD. What does this mean going forward? Here are two takeaways from Bank of America Merrill Lynch:
Here is their view, courtesy of eFXnews:
Fed signals December hike
The FOMC clearly signaled a hike before the end of the year in both the language and the dots. The Fed made two important changes to the statement.
First, the committee noted that near-term risks to the economic outlook “appear roughly balanced“. This is an important step for the Fed to justify hiking rates at an upcoming meeting and is a page out of the playbook from last year. We expected the Fed to make thislanguage change.
Second, the FOMC noted that “the Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of further progress toward its objectives.“ This is a strong signal that the Fed is planning to hike in an upcoming meeting. It is not explicit calendar guidance, but it is a small step in that direction.
USD: What’s Next?
The dollar was mixed in the wake of the FOMC statement. Cross-currents in the statement between three voters dissenting in favor of hikes combined risks to the outlook now being seen as nearly balanced were offset by downward revisions to the 2016-2018 dot plots. On balance, as we expected, today’s meeting set the stage for a December hike, which will keep the USD supported (and downside limited).. But the slower pace of tightening as implied by the dots will limit USD upside to an extent as the magnitude of policy divergence continues to diminish with the Fed now only seeing 2 hikes in 2017 and 3 in 2018. As we have argued, a necessary condition for the dollar to rally is a more consistent pickup in US data so the market can price a faster pace of hikes in 2017/18. Until then any rallies will seem shallow particularly with the market already pricing a 60% of a hike.
The gradual pace of hikes implied by the SEP helps to maintain the divergent path of policy between the US and G10 economies, many of which continue to expand their balance sheets and ease policy. However, as the BOJ‘s action overnight highlighted, central banks are increasingly reaching the limits of policy. We see the higher real yields our US Rates team expects as USD-supportive, but a key risk is an inability for non-Fed central banks to generate inflation thereby pushing real yield differentials against the dollar.
Bottom line, the dollar will remain supported with the Fed on course to hike in December, but the magnitude of moves willbe hindered by the slower pace of hikes implied by the lowering of the 2017/18 dots in today‘s SEP.
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