Dollar Risks Tilted Lower: Fed Preview from TD Securities

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Risks to the Dollar are tilted to the downside, according to a new tactical preview of the looming Federal Reserve interest rate decision and policy update conducted by TD Securities.

The Federal Reserve Open Market Committee (FOMC) is expected to announce at 19:00 GMT that interest rates will remain at current levels, which is widely anticipated by the market, meaning any volatility from the event will come from the guidance regarding a potential December interest rate hike.

"The Fed will likely maintain a broadly hawkish policy tilt, consistent with the September dot plot. However, the Committee will reiterate that it aims to "proceed carefully" as it formulates the next policy steps," says Oscar Munoz, Chief U.S. Macro Strategist at TD Securities.

The strategy team at TD Securities have a base case scenario (70% chance) that Fed Chair Powell underscores that while economic data since the September meeting has turned out unambiguously firm, the Fed can afford to be patient as it gathers more data.

Under this scenario, Powell will likely point to the progress achieved on inflation and the recent tightening of financial conditions as reasons to proceed more carefully.

"However, the chairman will also flag that another rate increase could be in the cards before year-end," says Munoz.

Under this base case scenario, TD Securities sees approximately 0.10% upside for the Dollar index, underlining the view that there is likely limited upside for the Dollar.

"For the USD, we see the bigger risks of a selloff on a dovish interpretation than a rally on a hawkish one. Much of this boils down to extreme, one-sided positioning and stretched valuations, especially as Fed speak has gotten more dovish recently," says Mark McCormick, Global Head of FX and EM Strategy at TD Securities.

But strategists attribute a slight 10% chance that the Fed errs dovish, whereby it signals less need for further rate hikes given the recent tightening of financial conditions (caused by the surge in longer-dated U.S. bond yields).

Here, even though activity indicators have gathered some steam, the Fed will say it can afford to be more patient given the progress made on bringing inflation down.

Under this hawkish scenario, the Dollar could fall by as much as 0.50%, according to McCormick.

The Dollar would, however, potentially rise 0.20% if the Fed errs 'hawkish' (20% chance) by pausing but "strongly hinting at the possibility of an additional rate increase before year-end".

In this instance, "the Fed downplays evidence of cooling inflation over the summer given recent strength in prices while also emphasizing that activity data and labour market dynamics are too strong for comfort," says Munoz.