Week Ahead: It’s all about central banks

Written by Hussein Sayed, Chief Market Strategist at FXTM

The greenback ended sharply higher against it major currency peers on Friday, boosted by stronger than expected inflation figures for the month of August. The rises in medical costs along with higher rents were enough to offset the declines in gasoline and transportation. The core CPI which excludes the volatile food and energy items climbed 2.3% in August when compared to last year suggesting that inflation in the U.S. might have started to build-up.

A rate hike is justified.

Theoretically, if the Federal Reserve acts upon its twin objectives of stable prices and maximum employment, then a rate hike is justified. Atlanta Federal Reserve Bank president Dennis Lockhart, already mentioned that 1.6% inflation and 4.9% unemployment rate call for a lively discussion when the central bank meets on September 20-21. Several other Fed officials also argued that recent economic data supports a rate hike as early as September, but will they?

Why not? 

Chances of pulling the trigger are very low and I will be very surprised if the Fed hiked rates for several reasons. 

• U.S. service industry which makes up more than 80% of the economy expanded at weakest pace in six years in August according to the Institute of Supply Management, indicating that there are serious signs of economic slowdown. 
• The manufacturing sector continues to struggle with weak business spending, slowing exports, strong dollar, and uncertain global outlook.
• Retail sales declined in August, diminishing hopes of strong rebound in growth which is led by consumers. 
• The race to the white house has tightened with Hillary Clinton’s lead declining considerably in the past several weeks. 

The market shares our view with only 12% priced in for a rate hike according to CME FedWatch, suggesting that investors are not well prepared for action, and even a dovish rate hike will create serious headwinds to financial markets. However, I believe that Janet Yellen will take the opportunity to start building the case for a December rate hike, which could continue sending the dollar higher. 

BoJ: Deeper into negative territory?  

The Fed is not the only central bank under traders’ radar. Bank of Japan is likely to provide more action on Wednesday with speculation of cutting rates deeper into negative territory is being considered as BOJ's massive economic stimulus proved insufficient to boost growth and inflation. 

The BoJ might also consider increasing purchases of short term bonds and reduce the ones of longer maturities, an operation change to steepen the yield curve by keeping short term borrowing costs low, meanwhile helping the financial system to find some returns on the longer run. 

The 2% inflation target set on January 2013 seems like mission impossible for the central bank to achieve in the next two years, so pushing the target again is highly anticipated but we don’t expect the BoJ to lower or drop their commitment as of yet. 

The Yen is not fully pricing in a rate cut, so a 10 basis point cut would drag the Yen lower with a potential of USDJPY reaching 105 over the short-medium term, but this also depends on what the Fed will do later on Wednesday.

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