Fed up with the USD?

The September FOMC decision is the main event this week despite the fact that the markets have all but discounted a September lift-off by now, expecting the first Fed hike to come in December instead.

Credit Agricole Research economists says it expects no change in rates on Thursday but think that the Fed lift-off could come in October. 

The price action in the G10 FX markets over the last week or so is very similar to what we saw ahead of the September 2013 Fed meeting that came on the back of a sharp market selloff and resulted in the FOMC delaying QE taper until December that year. Indeed, the USD lost ground of late against the likes of Scandies, AUD, EUR and GBP, and the question is whether the Thursday's Fed meeting will usher yet another leg lower in the currency. 

"We doubt that the latest underperformance of USD will grow into a sustained downtrend. In particular, we suspect that even if the Fed were to leave rates unchanged on Thursday, the language of the statement and the press conference as well as the latest growth and inflation projections will leave no doubt of the policy makers' intentions to hike rates later this year," noted Crédit Agricole Research.

A Fed hike which is only a matter of time should help the USD regain ground on the back of sustained (and growing) rate advantage. This advantage would be particularly pronounced against currencies where central banks continue to worry about the growth and inflation outlook like the ECB and, we would expect, the BoJ. All that could still mean that the medium-term risks for EUR/USD should be on the downside and for USD/JPY, on the upside. 

Another reason that is often used to explain the inability of USD TWI to break above its cycle highs (first hit in March and revisited again in August) is the observation that USD rarely held on to its pre-lift-off gains once the Fed started tightening in the past.

The current conditions - elevated risk aversion and global macroeconomic uncertainty - are very similar to that in 1997 and 1999. The similarity to these episodes is further enhanced by the fact that USD is now one of the highest yielding G10 currencies as measured by the spread between 10y UST yields and G9 bond yields. Back in 1997 and 1999 the USD remained supported following the Fed lift-off especially against risk-correlated and commodity currencies.