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Three FX Takeaways From the FOMC Minutes

Reading through the FOMC minutes last night, we took away three key points for the FX market.

  1. The Fed felt that the appreciation of the dollar was helpful in suppressing import prices and contributing to the Fed's objective of bringing inflation back to its 2% target. In other words, the Fed seems to welcome dollar strength and there were no linkages of dollar strength depressing any sectors in the US economy.
  2. The Fed noted that the dollar had continued to strengthen in the inter-meeting period, especially against the euro. The Fed blamed the move on wider interest rate differentials. We see these interest rate differentials (two-year swap differentials) widening further into year-end and keeping EUR/USD pinned down near these 1.00/1.02 levels.
  3. The Fed acknowledged the risk of tightening more than necessary - a risk that in effect justified slowing the pace of rate hikes and shifting to a more data-dependent approach. Within FX markets, selective high-beta, risk-sensitive currencies may perform a little better on the view that the Fed is shifting away from the period of more forceful adjustments in the policy rates.

As James Knightley notes, there are still three big event risks ahead of the 21 September FOMC meeting which will help determine whether the Fed hikes 50bp or 75bp. These are the Fed's Jackson Hole symposium (25-27 August), the August jobs report (2 September) and the August CPI data (13 September).

How should FX markets trade beforehand? The surge in gas prices has been dominant in FX markets this week and the theme of energy dependence suggests the dollar remains bid against the euro and yen. The wild card of another renminbi devaluation also hangs as a spectre over most currencies (except the dollar), but many assume the People's Bank of China will not allow the renminbi to substantially depreciate ahead of the all-important National Congress sometime in November. Let's see.

The more data-dependent approach from the Fed is a slight positive for the risk environment and favours selective carry. Last week we highlighted that a cross rate like MXN/JPY might perform well (MXN 3-month implied yields are near 10%) and we still like this strategy.

The US data calendar is quiet today and DXY can trade near the top of a 106.50-107.00 range.