USD Into FOMC: Will This Be The Start Of A New Trend? - BofA Merrill

"Fed may send conditional hints of upcoming hike:

The Federal Reserve meeting on September, 21 is likely to be eventful. While the FOMC is unlikely to deliver a rate hike, we think the committee will have to communicate that a hike is still likely before year-end. This means that the communication would have to sound cautiously hawkish, which is not an easy task.

We expect the FOMC to note that the balance of risks are nearly balanced and for the dots to shift down by 25bp across the curve. In our view, Fed Chair Yellen is likely to make the case for a hike before year-end in the press conference, but with an emphasis on the fact that it is dependent on continued improvement in the data.

FX Implications: Start of A New Trend?

The "cautiously hawkish" tone that we expect from the FOMC meeting is likely to be mildly USD-supportive, but we doubt it is the start of a new trend.

An upbeat economic assessment and nearly-balanced economic risks would support market pricing for a December hike, limiting USD downside, in our view. However, with the market pricing just over one hike between now and end-2017, we believe a necessary condition for the USD to rally is a consistent pattern of better US data allowing the market to price a meaningful pace of hikes in 2017 and 2018. Until then, the USD is likely to be range bound. That said, a residual expectation for Fed hikes is likely enough to limit significant USD downside given most G10 central banks are easing, but the dollar is unlikely to rally either.

Additionally, the recent shift by our US Rates Team's to a short real rates stance also suggests USD risks are more on the upside than the downside. The USD has benefitted over the past week as US real yields have risen between 6 and 18 basis points, driving a steepening of the rates curve. While the USD is typically negatively correlated with the shape of the yield curve, it has rallied because the curve steepening has been driven by real yields a relationship we have highlighted on many occasions. Should a real rate-led steepening of the curve continue, we would expect the USD to benefit. Indeed, the dollar continues to look undervalued relative to real yield differentials as we have noted recently.

However, we believe there are two risks around real yields for the dollar.

First, if the Fed were to more explicitly (through its Sep forecasts or communications) signal it will strategically overshoot its inflation target, real yields will fall, breakevens will rise and the USD will suffer. Our base case does not see this as a possibility for the September meeting, but Ethan Harris has argued the Fed could adopt this strategy to extend the business cycle allowing more room for rates to rise. Some belief that the Fed would stay 'behind the curve' on inflation earlier this year was a key reason for the USD selloff.

Second, if the BoJ focuses, as we expect, on maintaining policy flexibility as opposed to implementing significant new stimulus, the market could again interpret this as a policy constraint, pushing Japanese real yields higher, equities lower, and leading to a stronger Yen. This sentiment could spread to the ECB suggesting the USD would likely struggle against its G3 counterparts. This is why the BoJ meeting (happening hours before the Fed next Wednesday) is likely to be more consequential for FX markets than the FOMC".

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