U.S. DOLLAR: POSITIONING AHEAD FOMC
The U.S. dollar rose to a 2 month high against the euro ahead of the Federal Reserve’s monetary policy announcement on Wednesday. Based upon the price action in the forex, equity and bond markets, traders across different asset classes are all positioning for a hawkish outcome from the Fed. This suggests that if there was a disappointment, it would come in the form of an unchanged rather than hawkish monetary policy statement. However this does not mean that a hawkish statement would elicit a weaker reaction in the forex market than a dovish statement because currency traders are not over weighted U.S. dollars. Instead, the tone of FOMC decision should determine how the dollar trades for the remainder of the year.
What to Expect from the Fed
The 3 things that investors will be looking for tomorrow will be the tone of the FOMC statement, changes to the discount rate and any plans to end emergency programs. The sharp moderation in job losses and improvement in consumer spending will encourage the Federal Reserve to grow more comfortable with the outlook for the U.S. economy. However there are still plenty of reasons why the Fed may not want to appear overly hawkish and therefore quite a bit of uncertainty rests with tomorrow’s FOMC statement. We only expect the bare minimum from the Fed because they realize that at this critical juncture in the U.S. recovery, there are more consequences than benefits to being overly hawkish. Although we believe that the Fed will underwhelm, dollar bulls may not need much to be satisfied and therefore any subtle changes to the language of the FOMC statement could affect how the dollar trades. A more upbeat tone by the Fed would be positive for the dollar while skepticism about the sustainability of the improvements in the labor market or consumer spending could reverse the greenback’s recent gains. For more on these 3 items that the market wants the Fed to address, read our FOMC Preview.
Economic Data: Good News and Bad News
Meanwhile a round of mixed U.S. economic data has not stopped the dollar from rising. Producer prices which measures wholesale level inflation increased 1.8 percent in November with core prices rising 0.5 percent. On an annualized basis, PPI rose by the strongest pace since October 2008. Unsurprisingly, the weakness of the U.S. dollar, rise in gasoline and other energy prices played a big role in pushing PPI higher but aside from a drop in the price of passenger cars and computers, stronger price pressures was seen everywhere. However unlike oil prices, gas prices fell gradually last month which means that even though we also expect consumer prices which are due for release tomorrow to rise, the pace of growth may not be as strong as PPI. Stronger inflationary pressures, a pickup in consumer spending and a dramatic improvement in the labor market should encourage the Fed to adopt a more hawkish tone on Wednesday. Unfortunately the sharp drop in the Empire State Manufacturing survey will make it difficult for the Fed to be anything more than cautiously optimistic. The index fell from 23.51 to a five month low of 2.55 which indicates that manufacturing activity slowed significantly last month. The only saving grace is the rise in industrial production in November and the increase in capacity utilization which suggests that the slowdown in the NY region may be unique to the Empire State. The Treasury International Capital flow report was conflicting with demand for long term securities increasing but demand for short term securities falling. However the key takeaway is that foreign officials which include central banks boosted their holdings of U.S. dollars by $14.6B, the largest increase in 4 months. Aside from CPI, the current account balance for the third quarter, housing starts and building permits are also due for release. The decline in the NAHB housing market index which measures builder confidence suggests that that like the manufacturing sector, the pace of activity in the housing market may have slowed.
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