Summary:

• The Federal Reserve meets on Wednesday – no changes in policy are expected
• The FED is stuck between weak inflation and solid employment growth
• The dollar could add to losses after the statement is published

Analysis:

On Monday, EURUSD hit its highest level in 2 years. It was not only because of the ECB’s meeting from last week, but also because of what’s going on in the US economy. US data deteriorated further, especially inflation and retail sales, which could be a worrisome sign for the Federal Reserve. The central bank meets on Wednesday and while no changes in policy are expected, the tone of the statement could decide on the direction of the USD in upcoming weeks.

The Fed has a tough nut to crack. The labour market seems to be in almost a perfect condition, but inflation has slowed markedly. In its last statement the central bank did acknowledge that it is monitoring inflation developments closely. However, the latest data was certainly something that the FOMC didn’t want to see. Growth in prices slowed, retail sales fell and soft indicators like the Philly Fed gave up part of their gains. That is why the market is currently at a crossroads and the outcome of the meeting could be surprising in either direction. According to the interest rates market, one thing is almost certain – the monetary policy won’t change at this meeting.

Wednesday meeting should be a non-event, at least according to what the market is pricing in. source: Bloomberg

 What’s important, the probability of a third rate hike this year has fallen below 50%. That definitely a bad news for the dollar, but in upcoming months the focus will be elsewhere. The FED is on the verge of shrinking its balance sheet and the decision could be made as soon as Septemeber. Let us recall that the FED has 4 meetings with press conference and macroeconomic projections, all of which take place in the last month of each quarter. That means that during July’s meeting we won’t hear from Janet Yellen, which sharply reduces a chance of a policy change. If so, an announcement on the balance sheet reduction is rather unlikely.

So what to watch for? As it was said, in the last statement the central bank admitted that it’s monitoring inflation developments closely. Since that time, the data on this front has weakened further. CPI was much weaker than expected, both core and headline measure. That’s why a hawkish twist is unlikely, which could add to dollar losses. 

The FED admitted that inflation could derail its rate hike plans. The data was much weaker than expected. source: Federal Reserve

In this case it’s worth looking at the USDJPY, a pair that is vulnerable to changes in the US monetary policy. A dovish outcome will be negative for rates, but also for the USD. That could push the EURUSD close or above 1.1700, and the USDJPY towards 110.00. On the other hand, the central bank could surprise (but it’s less probable). In this scenario the USDJPY could head to 112.10, an important resistance.

 USDJPY awaits the outcome of the FED’s meeting. A dovish one could push it below 110, while a hawkish could lead to a move towards 112.10.