USD - joining the dots - Rabobank

"In June the FOMC published details on how it will approach balance sheet reduction. Since then there have been signals from some committee members that the September policy meeting may be an appropriate time to announce when this procedure will commence," Rabobank analsysts note.

Key quotes:

"In theory, balance sheet reduction is a USD positive factor.  Even though the Fed will be reducing the size of its asset pile at a slow and gradual, it still amounts to a reduction in USD liquidity.  That said, the news that the process is about to start should already be in the price and, despite the interest rate hikes already announced by the Fed this cycle, US monetary conditions remain very accommodative when measured from a historical basis.  On balance, it is likely that the USD is likely be more sensitive today to any news regarding the FOMC’s position on the inflation outlook."

"At the July FOMC meeting, policymakers appeared to be as odds about the US inflation outlook. Many measures of price pressures have been undershooting market expectations recently which we would argue doesn’t sit well with the dot plot that the Fed published in June.  The hourly earnings measure in the August US employment report printed a disappointing 2.5% y/y rise, well below the highs of previous cycles.  In tune with subdued wage inflation, core CPI inflation stood at 1.7% y/y in August with the core PCE rate registered a moderate 1.4% y/y.  In June, the message was that the Fed was still preparing for another interest rate hike.  The dot plot that is published today will either support this message or signal that the next hike will be pushed back.  Currently the market implied probability of another rate hike by the end of the year stands at around 53%.  This probability could move significantly in either direction on the back of the Fed’s statement today.  On balance we would be sellers of the USD given our dovish Fed call, though we do not expect the USD weakness to pick up much steam." 

"How far the USD can soften in the months ahead could be limited by the fact that the market is already maintaining short USD positions. This should make the greenback more reactive to positive news than to negative factors.  Positioning is contributing to our view that EUR/USD could find it difficult to move significantly in either direction in the coming months even if the Fed confirms a more dovish policy bias today.  While we remain constructive on the outlook for the EUR, the build-up of long EUR positions should dampen the unit’s reaction to positive news going forward.  We are forecasting a move to EUR/USD1.25 by the middle of next year but on a 1 to 3 mth view we see scope for consolidation around current levels." 

"While the major central banks have reasserted their influence on the markets over the past couple of weeks, political factors remain not far from the spot light. Yesterday US Senate Republicans reached a budget compromise over tax cuts and budget deficits that would reportedly allow tax cuts over the next decade.  This, however, is viewed only as a start to the tax overhaul effort.  The full Senate will still have to vote on the budget and, in view of their slight majority, Republicans can only afford to lose two votes from their 52 members.  Then, their deal would need to be aligned with the House budget.  After this it is likely that bills that will be proposed by the Senate and the House could have significant differences.  For now, the market is likely to remain sceptical about the prospect and pace of tax reform in the US, at least in the coming months.  That said, any constructive news on the US fiscal front is likely to trigger short covering and is a risk to our medium-term bearish USD view. "