FOMC Preview – Taper Talk And Impact On Dollar

The outcome of Wednesday’s Federal Reserve monetary policy announcement could set the stage for how the U.S. dollar and currencies trade over the next month. With that in mind, the greenback maintained its bid ahead of rate decision. USD/JPY hovered near 2-month highs above 110 as EUR/USD held below 1.2150. Today’s U.S. economic reports were supposed to have a big impact on trader positioning into FOMC and the fact that investors ignored weaker reports is an important sign of how sentiment is skewed into the event. They continue to look past weak data in favor of rising prices and a stronger recovery.

Retail sales fell -1.3% in the month of May, which was significantly weaker than anticipated. With declining auto supply, economists forecasted a decline in spending but they expected retail sales ex-autos to rise by 0.2%. Unfortunately, core retail sales fell -0.7% as consumers shift spending from goods to services. Demand for home improvement gave way to more experience spending on restaurants and lodging. Manufacturing activity in the NY region also grew at its weakest pace in 3 months according to the Empire State survey. Yet the dollar’s buoyancy tells us that investors expect the Fed to cave to rising prices and address rather than avoid the issue of reducing asset purchases, especially with producer price growth hitting a record high.

Investors need to beware of the potential for disappointment from the Fed. U.S. policymakers have insisted on every occasion that the rise in prices is transitory and will fall as pent-up demand and supply chain disruptions ease. The prospects for the recovery are strong, but consumer demand and job growth over the past 2 months have been subdued. Like the ECB who avoided taper talk last week, if the Fed is cautious, they’ll want to wait for real data improvements before admitting that it is time to start talking about tapering their $120 billion a month bond-buying program.

On the one hand, however, market conditions are ideal for taper talk to begin. Stocks are strong, volatility is low and investors are optimistic which provides a cushion for a deep correction. By vaguely mentioning that they are looking into reducing bond buys, they give investors an entire summer to discount the changes before the Fed’s Jackson Hole summit in August.

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