US Dollar Eases as China Tariffs Go into Force, Gets No Help from FOMC

-FOMC eyes inflation "overshoot", to continue "gradual" hikes.

-ISM non-manufacturing index posts surprise increase for June. 

-US/global growth and interest rate divergence theme is key for USD.

© Robert Cicchetti, Adobe Stock

The US Dollar weakened Friday after minutes from the latest Federal Open Market Committee (FOMC) meeting gave no fresh impetus to the greenback, at a time when markets are on edge over a possible escalation of the so called trade war between the US and China. 

FOMC meeting minutes from June show that US rate setters are both optimistic over the economic outlook as well as concerned for it, as on the one hand growth is being stimulated by President Donald Trump's tax cuts and on the other, it is being challenged by a White House trade policy that has take the world to the brink of a so called trade war. Concerns over trade policy are unlikely pronounced enough to deter the FOMC from pursuit of "gradual" interest rate rises.  

Most importantly, rate setters were more concerned about rising inflation pressures during their latest meeting than they were about the prospect of consumer prices undershooting the 2% Fed target, marking a reversal of a long term trend among FOMC members toward concerns over low inflation. US inflation hit 2.8% in May while core inflation was 2.2%, leaving both numbers above the Fed's 2% target, which led FOMC members to voice concerns over "heightened inflationary pressures" at the June meeting. 

"These minutes don't give the impression that a clear majority is ready now to abandon the idea that the risk are “roughly balanced" or that "gradual" rate hikes are no longer enough. That day is coming, but likely not until December, by which time we think unemployment will be 3.5% or less, wage growth will have picked up appreciably, and, we hope, trade policy will be more rational," says Ian Shepherdson, chief US economist at Pantheon Macroeconomics.

The US Dollar index was quoted 0.14% lower at 94.27 during the morning session Friday and is now up 2.14% for 2018. The Pound-to-Dollar rate was 0.05% higher at 1.3228 while the Euro-to-Dollar rate was 0.14% higher at 1.1707.

US rate setters raised the Federal Funds rate range to between 1.75% and 2% last month, from 1.5% to 1.75% before, and added another black mark to the so called "dot plot". The dot plot now shows a majority of Federal Open Market Committee (FOMC) members expect to raise rates two more times in 2018 and three more times in 2019.

FOMC members also made the decision to hold press conferences after each and every future meeting, rather than the quarterly conferences the Fed has held until now, suggesting the next hike could come at any other meeting this year.

Markets had become accustomed to the idea the Fed would only raise rates on four specific dates, all corresponding with a press conference, annually.

"Those looking for dovish developments are placing most of their hopes on a growing chorus of Fed members fretting about the flattening yield curve, and at the margin any perceived risks to the economy from US trade policies, but we suspect that the Fed is set to continue hiking for now until incoming data points to a need to do otherwise," says John Hardy, chief FX strategist at Saxo Bank. "The market has only priced 65% odds of a September hike and less than 50/50 odds that we see two hikes through the December FOMC meeting."

US-China Trade War Escalates

The Dollar has converted a 4% 2018 loss into a 2.8% profit during the two months since the middle of April. Most analysts now agree that superior levels of growth have bolstered the case for the Federal Reserve to keep raising its interest rate, at a time when the interest rate outlook elsewhere in the world is deteriorating, which has incentivised traders to sell other developed world currencies and buy Dollars.

However, those arguing for further US Dollar gains and further Fed rate rises are increasingly being challenged by President Donald Trump's trade policies. Trump has been pursuing restrictive legislation to govern Chinese investments into the United States and recently ordered that a range of tariffs be levied against imports of more than $250 billion in American imports of Chinese goods.

The latest tariffs came into force on Friday, drawing an immediate pledge of retaliation from China that could merely beget an even heavier response from the US. US trade representatives said last month they would announce another $200 billion of tariffs against China if it responds to the levies that came into force Friday.

Trump has also levied new tariffs on all imports of steel and aluminium from China, Canada, Mexico and the European Union. He is seen as attempting to reduce the US trade deficit after citing it repeatedly as a sign of malpractice by other countries and evidence that protectionist action is needed by the White House.

The moves so-far have drawn retaliation and threats of even further reciprocal measures from the Chinese, which all comes on top of earlier White House tariffs on imports of steel and aluminium into the United States from across the globe, including the European Union.

The EU has since responded with its own levies on US motorcycles, jeans and whiskey, drawing threats of even more tariffs from the White House, this time targeting the mighty European automotive sector.

Fears are that a tit-for-tat tariff fight between the world's largest economies will quickly descend into an all out "trade war" and that this will dent economic growth in all countries it touches, which could stymy the Federal Reserve from raising its interest rate further while also denting the odds that other central banks will be able to raise their rates any time soon.

US Economy Gathers Momentum

The US Dollar had pared losses Thursday as traders rewarded a surprise increase in the June ISM Non-manufacturing PMI, which measures activity in the US services sector, while taking up positions ahead of the release of minutes from the latest Federal Reserve meeting. 

The ISM Non-manufacturing PMI rose to 59.1 for the month of June, up from 58.6 previously, when economists had been looking for it to ease lower toward the 58.3 level. The index has pointed to robust growth in the US services sector for more than 100 consecutive months now and remains close to the post-crisis high seen at the beginning of 2018.  

Overall business activity in the US services sector rose by 2.6% during the month, according to the Institute for Supply Management, while new orders also rose by close to 3%. On the downside, the employment sub-index slipped by around 0.5%, suggesting the pace of jobs growth in the sector cooled a touch during June. 

"Today's ISM report indicated a rise in the rate of expansion of the services side of the economy in June," says Katherine Judge, an economist at CIBC Capital Markets. "The better than expected print suggests that the US economy ended Q2 on solid footing and supports our above-4% growth estimate for the quarter."

The US Dollar index was quoted 0.19% lower at 94.35 following the release Thursday while the Euro-to-Dollar rate was 0.31% higher at 1.1697 after having briefly pared its advance. The Pound-to-Dollar rate was 0.02% lower at 1.3224 while the Dollar was lower against all developed world currencies other than the Japanese Yen. 

PMI surveys measure changes in industry activity by asking respondents to rate conditions for employment, production, new orders, prices, deliveries and inventories. A number above the 50.0 level indicates industry expansion while a number below is consistent with contraction.

Markets care about the data because they are important indicators of momentum within the manufacturing and services sectors as well as the broader economy. Economic growth has a direct bearing on inflation and it is consumer price pressures that dicate where interest rates, which are the raison d'être for most moves in exchange rates, will go next.

"The small increase in the ISM non-manufacturing index in June underlines the current strength of domestic demand. Taken together with the increase in the manufacturing index reported earlier this week, a weighted average of the two points to GDP growth of over 5% annualised," says Michael Pearce, a senior US economist at Capital Economics.

Earlier this week the ISM Manufacturing PMI appeared to vindicate recent economist forecasts that the rate of US GDP growth could have topped 4% during the second quarter. Preliminary GDP data will be released later in July.

"US data has been very strong of late and there's no reason to expect that to change much. By the same token, anything the FOMC discussed which encourages speculation of a faster pace of hikes or a higher peak, is likely to worry trade and US rate sensitive currencies in the current climate. We still like being short USD/JPY around here," says Kit Juckes, chief FX strategist at Societe Generale. 

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