Analysts’ Pick: Powell’s speech fails to push DXY back down to retest 92.26, but will we see it today?
- The market’s reaction to the Fed’s announcement suggests that an average 2% inflationary target was likely already priced in, but it does also signal that with flexibility comes uncertainty among investors
- Our outlook for the dollar remains unchanged over the long-term, a slow and continual decline for the dollar with some upside corrections along the way
- Low rates may be here to stay as a result, with high unemployment likely to weigh on aggregate demand and consequently inflation
- The Dollar Index may experience higher volatility today and range closer towards the low of 92.26 as the BEA’s consumer spending report should continue to show household income continuing to stall thanks to job security concerns
- Consumer spending should also continue to ease as consumers start to limit purchases as they dip into the extra savings from the lockdown period
Effects from Fed Chair Jerome Powell's speech should spill over into trading today as investors around the world better absorb the decision for the central bank to implement average inflation rate targeting. Here is what we know from Powell's Jackson Hole speech last night and from comments from various Fed officials:
- The current inflationary target of an upper limit of 2% will be changed to an average target of 2%, allowing the central bank to overshoot its limit for a period of time
- No mathematical approach is expected this far, but the upper limit of the range may be moderated to 2.5%
- The Fed plans to undertake a thorough public review of its tools and strategy roughly every five years
- The shift to an average inflationary target without a formulaic approach suggests flexibility is the key consideration for policymakers moving forward
While this was mostly expected, the dollar experienced an initial swing along with other financial assets as the explicit statement from Powell came as a surprise to investors. The resulting impact on financial markets can be broadly be defined as increased risk appetite along with growing cautious optimism (stocks in riskier sectors led gains while safer sectors were mixed, the dollar ended largely mixed against other G10 currencies, gold dipped another 1%). The movement in the dollar (as well as gold) can be indicative of possible uncertainty on the future of policy decisions from the Fed, as well as missed expectations on the upper limit of the Fed's decision as comments from Fed officials signalled that it was likely that the upper limit of the average range of inflation would be around 2.5%.
The Dollar Index’s swing on the announcement of the average inflationary targeting mandate
The more plausible reason for the large swing trades that resulted after Powell's speech may be the uncertainty on the future of policy decisions. Flexibility may mean that the Fed will allow US inflation to reach as high as 2.5%, but the question is whether it can reach that level. This looks unlikely to be the case in the short-to-medium-term since the impact of the unprecedented levels of stimulus is likely to be offset by dampened demand due to the high levels of unemployment looking set to be sustained for a prolonged period of time.
Layoffs and unemployment look to be flattening, but at or close to record high levels
Moreover, the greenback looks to have already priced in low interest rates for an extended period of time, along with the downward pressure from record levels of stimulus from the US government and Fed. On the stimulus front, Democrats and Republicans still look to be far from an agreement on the upcoming fiscal stimulus measures. A reason for the stall may also be political, since both parties are ramping up their respective campaigns for the November presidential elections.
Biden still commands a good lead over US President Donald Trump but uncertainty will likely continue
Moving forward, it does seem that the impact of the Fed's statements on the dollar may only be limited since Powell's speech has laid out a rough roadmap for the future of monetary policy. We see interest rates staying low for the foreseeable future, until unemployment starts to show signs that it is on a robust road to recovery, i.e. initial jobless claims declining consistently back towards pre-Covid-19 levels and businesses restarting investments into new projects. Taking the environment after the Great Recession as reference, the Fed would likely have been able to postpone hiking rates to much later in the economic cycle, probably somewhere in 2018 instead of the first hike in 2015, assuming all other factors remained the same. The new mandate is likely to prevent what happened back during that period, and allow inflation to overshoot the 2% target level to encourage better inflation expectations (which the Fed believes to drive real inflation).
Consequently, the dollar may be especially volatile on the release of the US Bureau of Economic Analysis consumer spending report for July today. Today's personal spending and income report may as a result be a strong driver for the dollar's performance today. Income should continue to decline as dividends payments fall and jobless benefits reach the upper end of its limits, but at a slower rate than before as the overall uptick in employment over the month should help to support wages. Similar to economists' forecasts of a 0.3% decline, we expect personal income to range between -0.3% to 0.0%. Personal spending looks more probable to feature a slower incline than June, as we anticipate spending to continue to outpace through the month of July as households utilise more of their savings from the lockdown earlier this year. The reason we see muted spending is due to firstly the expiration of enhanced unemployment benefits which should more greatly impact lower income households, and secondly the pressure from uncertainty due to the high rates of retrenchment. Investors will likely be closely watching core PCE moving forward as well, but we do not expect much surprise in that department as it continues to stay low with downward pressure from reduced aggregate demand.
Our outlook for the dollar this week remains the same, with expectations for the Dollar Index to close the week below the 92.60 support level and range closer towards the recent low at 92.26 today. We may also see the index break the 92.26 support in intraday trading and possibly hit 92.13’s level. Over the medium-term and longer-term, we still see the dollar continuing its downward trend, but at a much slower rate than before with multiple upside corrections moving forward and eventually break below the support at 91.92, possibly ahead of the November elections. This is due to the impact of lower-for-longer interest rates, coupled with record high unemployment figures looking likely to stay for a prolonged period of time, implicitly reducing employability and weighing on the labour market for an extended period of time. The velocity of the record high levels of stimulus is also a concern, with an additional minimum of US1 trillion still expected to eventually be passed through Congress, which will no doubt continue to weigh on the dollar's reserve currency status in the medium-term. That said, we also do not see the dollar losing its reserve currency status to other major currencies in the near future, only a possible weakening of that status until a favourable alternative appears, probably in the form of a digital currency.
The dollar experienced a large swing the moment Powell announced the decision to shift inflationary targeting to an averaging one, with DXY dipping sharply before reversing all of the losses to close the day near flat. Fundamentals tilt the dollar to the downside, with technical indicators signalling that there is still room for DXY to continue to fall before reaching oversold levels. RSI is inching closer to wards the oversold level at 30.00 but yet to fully develop into a strong buy signal, while MACD suggests that the dollar has entered a downcycle. This is inline with our expectations earlier this week, despite the underperformance coming slightly later than expected. We still see the dollar falling closer towards the recent low at 92.26, although this will likely be a strong support level, meaning that short covers may happen here, especially since price movement after Powell’s speech suggested that DXY’s downside may be limited moving forward.
Support: 92.26 / 91.92 / 91.58
Resistance: 92.60 / 93.33 / 93.99
DXY Chart (H4)