FOMC Preview: Will A Rate Cut Stem Further EUR/USD Declines?

Federal Reserve interest rate announcements have traditionally been big market movers for the US dollar, but with the markets weighing the odds for a pause in the Federal Open Market Committee’s rate cut cycle, this week’s decision could prove to be a pivotal point for the markets. Currently, futures markets are pricing in an 84 percent chance of a 25bp cut to 2.00 percent on Wednesday afternoon, but given signs that a hawkish bias may be emerging within the FOMC, they are also pricing in a 16 percent chance that the Committee will leave rates unchanged for the first time since August 2007. Regardless of how the FOMC votes, the news has the potential to spark significant volatility not only for the US dollar, but also the Treasury and US stock markets.


As indicated in the data tables above, the majority of US indicators reflect major weakness in the US economy. As consumer sentiment has waned amidst rocketing energy costs and crumbling equity markets, personal spending has slowed. Indeed, while Advance Retail Sales reflected an improvement in March, this was purely the result of rising gas prices, as the index is not adjusted for inflation. Indeed, the non-manufacturing sector in general – which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance – is looking rocky as the March ISM survey remained in contractionary territory, despite a mild improvement. Likewise, the manufacturing sector isn’t faring well as the depreciation of the US dollar has done little to boost export demand. Producers are also grappling with high raw material costs that they are unable to pass on to their buyers, and as a result, profit margins are narrowing. Labor market trends do not bode well for growth either, as non-farm payrolls have fallen negative for three consecutive months and are expected to do so again when NFPs are released this Friday. With finance-related companies, among many others, likely to shed even more workers as the market turmoil persists, employment conditions may continue to sour as well.
What about the housing sector? Pending, new, and existing home sales are still showing declining purchases as supply far outweighs demand; not to mention that restrictive borrowing requirements make it difficult for even the most credit-worthy to get a mortgage. The most frustrating development for the Federal Open Market Committee, however, is inflation: while headline CPI held steady at 4.0 percent in March, core CPI growth accelerated, suggesting that the massive gains in energy and food prices are feeding through into all consumer goods. Overall, nearly every growth indicator we follow points to additional rate cuts by the FOMC on Wednesday, but with inflation becoming uncomfortably high, the concurrent policy statement could contain a hawkish tone.


The Odds are in Favor of a 25bp Cut
According to a Bloomberg News poll, the median of a survey of 72 economists shows that they are overwhelmingly in favor of a 25bp cut to 2.00 percent. Indeed, futures have generally been in favor of such a move since the last policy meeting, though for a time, the markets had considered the possibility of a 50bp reduction. However, the combination of stronger-than-expected CPI figures and hawkish comments from various FOMC members was enough to erase the probabilities of an aggressive cut to 1.75 percent. Nevertheless, economic conditions clearly remain very weak and are likely to get worse, supporting the case for additional rate cuts. Furthermore, credit conditions remain tight and financial institutions continue to writedown billions of dollars in losses. So how will the impact the US dollar? A 25bp reduction will not be enough on its own to take the wind of the greenback’s recent rally, and if the FOMC’s policy statement indicates a pronounced focus on inflation rather than credit conditions, the financial markets, or the economy, the US dollar could actually rally as traders rush to price the potential for a pause in further rate cuts for the rest of the year.
…But Will Higher Inflation Lead the FOMC to Leave Rates Unchanged?
As we mentioned above, FOMC commentary and hot inflation figures led the markets to cut back speculation of a sharp 50bp cut. However, it’s worth noting that during the past two policy meetings, über-hawk Richard Fisher has dissented in favor of ‘less aggressive’ policy action, while Charles Plosser did the same during the March 18 meeting. There is no doubt that the central bank is concerned about price stability, as the FOMC noted ‘elevated’ levels and indications that inflation expectations had risen. As a result, the markets are likely to see at least two votes for no change in policy, but the majority of the FOMC is highly unlikely to do the same given current economic conditions. Nevertheless, a surprising decision to leave rates unchanged will undoubtedly lead the US dollar to rocket higher, but the ensuing volatility could easily shake out positions with even the widest stops, so traders should beware.


The technical outlook for the EUR/USD pair reflects 5 waves down from 1.6018, confirming that an important top is in place. The rally from 1.5554 to 1.5694 is in 3 waves, which is corrective. There are multiple reasons to treat 1.5694 as the top of wave 2. One, 1.5694 is in the vicinity of the prior 4th wave (a common occurrence). Second, EURUSD has already dropped below 1.5554 (bottom of wave 1). For wave 2 to end above 1.5694, the pair would have to trace out an expanded flat, which is more common in 4th waves. As such, expectations are for the EURUSD to decline in either a 3rd (or C) wave. As long as 1.5694 is intact, bearish targets are 1.5230 and 1.4943 (100% and 161.8% extensions of the 1.6018-1.5554 decline). This works well with our view that the upcoming FOMC rate decision could result in US dollar strength on the back of a hawkish policy statement or no actual rate cut.




Written by Terri Belkas, Currency Analyst, and Jamie Saettele, Technical Strategist
of DailyFX.com

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