Dollar Strengthens as Fed Refrains From More Stimulus

The Fed is inclined to stay the course, ending Q2 at the end of the month and reinvesting expiring securities, according to the FOMC statement and press conference. The economic assessment was downgraded and there was no hint at QE3, leading to risk aversion and a dollar rally. Look to the HSBC China PMI to help set the tone in Asia-Pacific trading.

In the hours leading up to the FOMC decision, jittery markets built in a concession for the possibility of further Fed stimulus. PIMCOs Bill Gross spurred the trade with a tweet that said QE3 could be unveiled at Jackson Hole in August. The market moves gave us a sneak preview of what QE3 might look like; gold surged, stocks gained and the dollar was weak, especially against risk currencies. When the statement failed to offer any hint at QE3, the moves unwound. Further moves (risk aversion) were a result of the Fed downgraded its economic assessment. Some downgrade was expected but there was also the possibility of the Fed presenting some optimism. The S&P 500 closed at the days low down 0.65% to 1287 in the first decline after four days of gains.

We see a compelling case to be made for longer-term USD/JPY shorts. In the coming months the market will pressure the Fed to embark on QE3 by unloading stocks. If the Fed holds its ground, the dollar will gain broadly on risk aversion but lose ground against JPY and CHF. If/when the Fed bows to the pressure, a dollar rout will commence. AUD and NZD will be the biggest winners but JPY and CHF will also benefit. We prefer using JPY over CHF here because a large portion of CHF inflows have been due to investors seeking a safe haven from the crisis in Greece.

An early look at CHINESE INDUSTRIAL PRODUCTION comes with the June HSBC MANUFACTURING PMI. This indicator has gained increasing clout in the past year. A soft reading here could collide with the negative post-FOMC sentiment to drive an ugly risk off trade on Thursday. The May level of 51.6 was a 10-month low; there is no consensus estimate but we suspect the market is priced for a slight improvement to around 51.9.