How to read the signals from tomorrow's Fed statement. Unclear signals from US CPI leaves markets guessing

By Raiko Shareef

The USD is softer this morning, helped by a soft inflation report, but also because of idiosyncratic strength from GBP and AUD.

Remarkably, NZD failed to follow AUD higher, and remains trapped below 0.64.

Core CPI inflation in the US undershot expectations in August, remaining steady at 1.8%. The pace of price growth is trickling higher, but is disappointing when set against the robustness in activity indicators. Furthermore, analysts note that part of the pick-up in the CPI series comes courtesy of rents, which has a lower weight in the Fed’s preferred PCE measure of inflation.

In itself, the miss would not have been enough to drive the broad-based USD weakness witnessed overnight. But GBP helped to spur a G10 rally, thanks to a robust labour market report. Unemployment fell slightly faster than expected, but it was the quickening in wage growth (2.9% y/y vs 2.5% exp.) that boosted the case currently being made by hawks on the BoE’s policy committee.

AUD also outperformed, though that looks technically driven, rather than off any fundamental news. AUD/USD broke above trend-line support that extended from June, and looks to break above 0.72 imminently. The 50-day moving average at 0.7260 should provide a cap, especially ahead of the looming Fed event risk.

NZD remains pinned at resistance at 0.6370, in part thanks to a break lower in NZD/AUD, which broke through support at 0.8870. A close below 0.8840 would be a negative signal, inviting a test of key support at 0.8780.

The local Q2 GDP report might provide some reason to break NZD’s tight range, but we’d be sceptical of large moves in front of the Fed.

On the meeting at 6am tomorrow, our NAB colleague Gavin Friend put together an excellent summary of the issues to watch for. It is reproduced below.

Fed Preview (from NAB’s Gavin Friend)

If the first headline is ‘Fed leaves rates on hold’, we need to look at four things:

- The dot points. These will be lower. In June the 2015 mid-point was +0.625%, 2016 1.625% and 2017 2.875%. Two hikes in 2015 and six by end 2016 ? Seems too high.

- In the new economic projections has the FOMC lowered the core PCE inflation forecasts for 2015 and 2016 and if so by how much?

- Has the Statement acknowledged inflation will take longer to rise back towards target? These issues will be key for market reaction, especially the USD.

- Chair Yellen’s remarks 30 minutes later. No inflation adjustment forewarns of a more hawkish press conference, leaving markets on notice for October or December hikes.

If the first headline is ‘Fed hikes…’, the USD and shorter yields will rise, equities may ease but it is guaranteed the FOMC will seek to mitigate any fall-out. So we need to look at:

- The Statement will justify the reason for the hike (better activity data, full employment)

- But the Statement will also note the Committee will take a measured and gradual approach to any further tightening (perhaps even not expecting back-to-back hikes) and expects the terminal rate to be lower than historically.

- The Statement may talk (bizarrely) about inflation potentially taking longer to return to target (buttressed possibly by slightly lower core PCE forecasts for 2015, 2016) to emphasize gradual tightening).

- The dot points will be lowered for 2015 and likely 2016 again to emphasis the slow and gradual pace of tightening.

- It will be down to Fed Chair Yellen to play down the hike and make sure the message of ‘gradual’ hits home.”

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Raiko Shareef is on the BNZ Research team. All its research is available here.