USD Sell-Off Continues On Dovish FOMC Minutes

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Three Key Takeaways from July FOMC Minutes

The minutes of the July FOMC cemented the dovish view that the market had of the meeting and caused a further unwinding of December rate hike expectations.  There was not much in the way of new information, but the further details added proved important, especially details regarding the balance sheet, inflation, and financial conditions.

1 – Balance Sheet

While some of the FOMC members were comfortable announcing balance sheet adjustment at the July meeting, “most preferred to defer that decision until an upcoming meeting” – such as September. This encourages the widely held view that the Fed will announce the beginning of its balance sheet adjustment at the September 19th-20th meeting. This aspect should be broadly Dollar positive, but in the context of the general tone of the minutes was unable to provide support.

2 – Inflation

The minutes showed that FOMC members had held a thorough debate around inflation and the path of future rate hikes. It is worthwhile to mention that at the July meeting, FOMC members had not yet seen the latest inflation reading (for July) which showed that just a single component (lodging away from home) was responsible for almost all of the downside surprise in core inflation. Nevertheless, at the point of the July meeting, core inflation had undershot expectations for four consecutive months (now five).

The minutes said that “most continues to anticipate that inflation would stabilise around the Committee’s 2% objective over the medium term” but that “many participants, however, saw some likelihood that inflation might remain below 2% for longer than they currently expected, and several indicated that the risks to the inflation outlook could be tilted to the downside”.

Members considered a number of issues that could be contributing to the weaker inflation environment including “idiosyncratic factors” and technical issues such as “residual seasonality” in PCE price inflation. Other reasons included were items such as whether inflation expectations are well anchored, the usefulness of the relationship between resource demand and inflation as well as pricing power from global developments.

The breadth of the issues considered suggests that there isn’t a strong consensus on the factors most important for the inflation outlook and reflects the Fed’s concern for the path of inflation which is now down five months in a row for the first time since 2006. Ahead of the September meeting the Fed will have received the August CPI print which will be a crucial reading; if inflation misses again, the market will take a December rate hike off the table but if inflation is able to rebound with less sizable contributions from “idiosyncratic factors” then the Fed’s conversation around inflation should be more reserved.

3 – Financial Conditions

The Fed’s conversation around financial conditions was another key element of the minutes. Despite having hiked rates on three occasions since December, financial conditions have continued to ease. The reason behind this easing was a key focal point in the meeting with several explanations offered including asset purchases by central banks, lowered inflation expectations and excessive risk taking by investors.

Regarding the implications of easier financial conditions, there were a variety of different opinions. One view suggests that previous rate hikes were “largely offset by other factors influencing financial markets and that a tighter monetary policy than otherwise was warranted”. Indeed, in an interview this week, New York Fed President Dudley referred to the easier financial conditions as one of the primary reasons for another rate hike this year. However, another view noted that “the recent equity price increases might not provide much additional impetus to aggregate spending on goods and services” arguing that easier financial conditions should not be used as an argument for further rate increases.

Judging The Likelihood of Further 2017 Rate Hikes

In terms of the path of future rate hikes, the minutes said that “most saw the outlook for economic activity and the labor market as little changed from their earlier projections and continued to anticipate that inflation would stabilize around the committee’s 2% objective over the medium term”. However, “some participants” noted their concern over subdued inflation and there were also “some participants” afraid of potential negative consequences from delayed normalization of policy rates”. Essentially, the committee appears to be split regarding the issue of raising rates.

Inflation Remains Key

Clearly, the most important issue in determining the likelihood of further rate increases this year will be inflation, if inflation remains subdued in the August reading, markets will move to price out a December rate hike, leading USD lower, while if inflation can recover in August alongside a more encouraging September FOMC, then a December rate hike should still be on the table.

Technical Perspective

For now, the USD Index is stalled at the 2016 closing low of 92.90 which has provided support just ahead of a test of the trend line support of the broad “megaphone top” pattern that price has been moving in for the last three years. If price can remain above the closing low, there is scope for a deeper correction higher though for now, in light of the recent decline, the focus remains on the downside.

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