Euro Steady Ahead of FOMC - Can The Fed Shock With A Rate Hike?

[DailyFx]

1.5550 has become the new level of equilibrium in EURUSD as the majors spend a quiet night of trade ahead of the marquee economic event of the week


Talking Points
• Japanese Yen: holds near 108.00 mainly off EURJPY demand
• Euro: 1.5550 new support as markets await FOMC
• British Pound: 1.9700 ceiling for now as traders await reaction from US
• US Dollar: Durable Hoods then FOMC on tap

Euro Steady Ahead of FOMC – Can The Fed Shock With A Rate Hike?

1.5550 has become the new level of equilibrium in EURUSD as the majors spend a quiet night of trade ahead of the marquee economic event of the week – the Federal Open Market Committee decision on US interest rates due 14:15 GMT today. Few market players expect any concrete change today with Fed funds futures handicapping the probability of unchanged rates at 90%. The focus of course will be on the post announcement statement as traders look for any strong clues to a potential rate hike in September.

In our FOMC Preview we note that the preponderance of US economic data over the past month has been nothing short of dismal as virtually every measure of economic activity has disappointed to the downside. Yesterday’s woeful US consumer confidence numbers which printed at a 16 year low were only the latest piece of evidence that US economy is on the verge of a complete stall. With oil prices continuing to hover stubbornly above the $130/bbl level effectively creating a slow but deadly chokehold on the US economy, the prospects for growth in the second half of 2008 look grim. With two more NFPs ahead of the September meeting, the Fed may be looking at an even weaker economic environment two months hence.

Therefore, in some perverse fashion it may be actually beneficial for US monetary officials to shock the market with a surprise rate hike today. The move would greatly bolster their inflation fighting credentials, by backing up the hawkish rhetoric of the past two weeks with an actual policy change. No doubt, the move would send equities into a tailspin, but it may also break the back of the oil market and finally force prices below the $130/bbl handle by strengthening the dollar and further dampening demand for crude. Thus with US economy already in a funk a little shock therapy today may do more good now than any vague promise to tighten rates in the near future.

On the flip side a non-committal statement from the Fed would likely generate only more dollar weakness. With ECB seemingly dead set on raising rates at it next meeting in July, inaction from the Fed would create further expansion of interest rate differentials between the euro and the buck. Ironically enough a neutral stance by the Fed would not necessarily cause dollar losses against the yen as equities could stage a relief rally. In fact, one of the best bets in a dovish Fed scenario may be a long EURJPY position which is already within striking distance of its all time highs and may make a run for the psychologically important 170 level on carry trade flows if the Fed does not produce a forceful message against inflation today.

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