US Dollar Outlook Favors Gains on Fed Rate Decision Outcome

Talking Points:

US Dollar to Rise on Hawkish Rhetoric Even if FOMC Forgoes a Rate Hike
Outright Tightening to Weigh on “Commodity Dollars”, Boost Japanese Yen
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The markets are firmly focused on the outcome of the Federal Reserve monetary policy meeting in the hours ahead. The split in economists’ expectations for the likely outcome is nearly even. A survey of 113 Fed-watchers polled by Bloomberg reveals a 59-54 preference for rates to remain unchanged this time around. The markets themselves are a bit more skewed in their priced-in outlook. Fed funds futures imply a 32 percent chance of a rate hike while OIS-based measures dismiss the possibility of such an outcome altogether.

On balance, this suggests a rate hike would amount to the most violent reaction from asset prices in that it would be a surprise to the largest contingent of market participants. Such a scenario is likely to deliver a strong advance for the US Dollar and weigh heavily on risk appetite, disproportionately punishing the sentiment-geared Australian, Canadian and New Zealand Dollars while offering haven-flow support to the Japanese Yen.

The absence of outright tightening may not be significantly market-moving in and of itself because that much is probably priced in. In this scenario, the focus will turn to text of the policy statement, the updated set of FOMC economic and policy forecasts, as well as the press conference with Fed Chair Yellen following the announcement. The cumulative take-away from these various components of the central bank’s forward guidance suite seems more likely to favor a stronger greenback.

The Fed has been stressing its preference to raise rates in 2015 since the beginning of the year. Most recently, key FOMC officials including Vice Chair Stanley Fischer made it explicitly clear that recent tumult in the financial markets has not decisively altered the central bank’s policy-setting calculus. This makes sense: the Fed’s “medium term” objectives are meant to be reached within a 2-3 year window, so a single month of jittery price action should not trigger an about-face on strategy.

With only two meetings left for the year, this means opting for the status quo this time will require a hawkish turn in official rhetoric. This will serve to set the stage for tightening in October or December, preserving the credibility in the Fed’s communicated intentions. While this would not generate as potent of a positive response as a rate increase, it would underscore the acute disparity between the trajectory of US monetary policy and that of the rest of the G10, boosting the benchmark currency.

Needless to say, the absence of a pro-tightening shift in commentary or the appearance of a dovish lean are likely to energize risk appetite and weigh heavily on the US unit. The probability of either scenario seems decidedly lower than the alternative.

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