Fed Preview: Two 5-Letter Words Could Make Or Break U.S. Dollar

The U.S. dollar traded lower against the euro and Japanese Yen ahead of Wednesday’s Federal Reserve’s monetary policy announcement. This sell-off was driven by a combination of lower yields and weaker economic data. New home sales, which were expected to rebound in June, declined for the second month in a row. With existing and new home sales falling, the overheated housing market could finally be cooling. Ten-year Treasury yields also dropped 4.4% as the S&P 500 ended the day lower for the first time in six trading days.

It is widely believed that the July FOMC statement will remain virtually unchanged. From the threat of the highly contagious Delta virus variant, expiring eviction moratorium and extra unemployment benefits, there are just too many uncertainties for the Fed to press the pedal on taper. U.S. data has also been mixed. Considering that most policy-makers believe that inflation is transitory, they can wait until their symposium at Jackson Hole in August or even September to see if these uncertainties have a significant impact on the economy. This afternoon, the White House said there’s “no significant signs” of economic impact from the Delta variant, but if restrictions in the U.S. returns, then the outlook will darken quickly. Just today, the Center for Disease Control and Prevention adjusted its mask guidance to recommend that fully vaccinated people resume wearing masks indoors in states where the virus is surging. It also recommended mask wearing in schools for teachers, staff, students and visitors regardless of vaccination status.

But if we are wrong and one of two five-letter words (Delta or Taper) make their way into the FOMC statement, we will see a big reaction in the U.S. dollar. If the Fed includes concerns about the Delta variant, the U.S. dollar could extend its slide quickly. If it shrugs off those worries and officially acknowledge that taper is coming, the U.S. dollar will soar. We don’t think either will make its way into the FOMC statement, but Fed Chairman Jerome Powell will be pressed to discuss both. He’s previously suggested that virus variants could complicate the U.S. recovery and there’s little doubt that he’ll express the same concerns tomorrow. However, when the Fed last met, it admitted that members talked about talking taper. And even if no official announcement is made on Wednesday, discussions will increase in the weeks ahead.

The sell-off in the U.S. dollar on Tuesday is a sign that investors expect more caution than optimism from the Fed. And if they are right, USD/JPY could extend its slide towards 109.00 and EUR/USD could squeeze above 1.1850. Unless there are significant changes to the FOMC statement or Powell’s outlook, we don’t expect big moves in currencies.

Unlike the euro and sterling, the sell-off in stocks and risk aversion drove the Australian, New Zealand and Canadian dollars lower against the greenback. Inflation numbers are due from Australia and Canada tomorrow, and while both reports are expected to be strong, the impact on AUD and CAD should be limited ahead of FOMC. The economic ramifications of lockdowns in Australia matters more to the central bank than inflation right now. For the Bank of Canada, higher prices validates its recent decision to reduce asset purchases.