"Now or Never" for US Dollar Bulls as Fed Remains On-Message and Tax Reforms Announcements Imminent

It is “now or never” for the US dollar to sustain an advance on the Euro and other currencies as conditions have ripened for the greenback in recent days.

The Pound-to-Dollar exchange rate has pulled back to 1.3374 in the mid-week session amidst a broad-based rally in the Dollar.

An easing of political concerns in Washington, expectations for imminent tax changes and an hawkish Federal Reserve have aided the US Dollar index to its highest level since August 28.

If the Greenback cannot sustain a bull-run in this environment, there is little hope for it.

“It’s now or never for Dollar bulls. Political concerns are growing a bit in Europe and EUR/USD still looks vulnerable to a deeper correction after this year’s quick-fire rally,” says Guy Stear, an economist at Societe Generale. "The short-term key is how hard the Fed wants to work to get markets to price in a December rate hike."

In addition, expectations are that Wednesday will yield some concrete details on a possible tax reform deal out of Washington.

“While we may see some headline-driven moves in US yields and the Dollar, we think markets have learnt their lesson from earlier this year of buying into tax reform promises too early,” says Viraj Patel, a foreign exchange strategist at ING Group.

The US Dolllar was quoted a fraction higher across the board during early trading. This pushed the Pound-to-Dollar rate down by 0.19% to 1.3416 while the Euro-to-Dollar rate was down 0.08% at 1.1773. The USD/JPY rate was 0.09% higher at 112.49 and the USD/CAD rate was up 0.02% at 1.2366.

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Yellen Cements Expectations for a December Interest Rate Rise

The Dollar has been struggling over recent weeks as markets appeared increasingly willing to doubt a December interest rate rise at the US Federeral Reserve.

However, the Fed has moved to reinforce its own guidance that such a rate rise is in fact still likely.

Wednesday’s comments come after Fed Chair Janet Yellen stuck broadly to the FOMC’s recent script on interest rates, in a speech delivered in Ohio, Tuesday.

The Dollar's gains were capped as Yellen chose to highlight risks around inflation forecasts that underpin both policymaker and market expectations for US rates going forward.

“While suggesting that the FOMC generally views the soft inflation numbers as transitory, she again gave credence to the notion that there is something structural going on in the economy that the Fed has yet to fully understand, which would warrant caution regarding the pace of hikes,” says Royce Mendes, an economist at CIBC Capital Markets. 

Tuesday’s address came closely on the heels of separate remarks by Vice Chair William Dudley and FOMC member Brainard, both of which were in line with the recent message and supported gains for the greenback. Yellen too gave as clear a signal as one could hope for that the Fed will still push on with its move to normalise policy regardless.

"Given that monetary policy affects economic activity and inflation with a substantial lag, it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent,” Yellen says. 

"This very powerful statement is of course perfectly in line with our baseline view for another 25bp rate hike in December," says UniCredit economist Dr Harm Bandholz.

CIBC's Mendes has concurs with Bandholz's sentiment, reiterating the bank's view that another hike to the Federal Funds rate is likely in December.

Yellen’s standing behind earlier forecasts for inflation won’t come as a surprise to anybody so soon after the September 20 policy statement, which caught markets by surprise when it confirmed that Yellen and her fellow rate setters will stay their earlier course. 

Nonetheless, questions around the assumptions underlying inflation forecasts may garner more attention over the coming months.

The speech, delivered to an audience at the National Association for Business Economics Annual Meeting in Cleveland, began with a reiteration  of previous commentary on the "transitory" nature of low inflation, accompanied by statements assuring that most rate setters expect it to return toward target over the next couple of years.

“But our understanding of the forces driving inflation is imperfect, and we recognize that something more persistent may be responsible for the current undershooting of our longer-run objective,” Yellen added, marking a departure from the usual monologue. “Accordingly, we will monitor incoming data closely and stand ready to modify our views based on what we learn.”

The US Dollar index, up 0.50% just ahead of Yellen’s speech, pared gains to be quoted just 0.38% higher at 93.01 a short time after the remarks were delivered.

The Euro-to-Dollar rate pared a 0.68% loss overhanging from the London session to trade just 0.52% down at 1.1794. This is while the Pound-to-Dollar rate was seen 0.29% lower at 1.3438.

“Although we judge that inflation will most likely stabilize around 2 percent over the next few years, the odds that it could turn out to be noticeably different are considerable,” Yellen continues, noting the potential for movements in oil prices, the US Dollar and other short term one-off variables to influence inflation.

But Yellen & Co see these kinds of influences as “transitory” and do not allow them to crowd the discussion on interest rates.

“A more important issue from a policy standpoint is that some key assumptions underlying the baseline outlook could be wrong in ways that imply that inflation will remain low for longer than currently projected,” says Yellen.

Labour market conditions that are not as tight as official bodies believe could be one of these mistaken assumptions, according to Yellen, so too is the FOMC’s estimation of the extent to which changes in employment impact on inflation.

In addition, broader economic influences such as the effects of globalisation could also pose downside risks to the FOMC’s inflation forecasts in ways that are not currently understood.

“My colleagues and I must be ready to adjust our assessments of economic conditions and the outlook when new data warrant it,” Yellen says, noting that if resource utilization and and longer term inflation expectations materialize lower than forecast in future, the FOMC can adjust its policy course.

“Moving too quickly risks over adjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock.28 But we should also be wary of moving too gradually.”