The market is holding its breath. Today's Federal Reserve meeting is a colossal threat to emerging market currencies, and an opportunity for the dollar as the Fed looks to begin discussions on how to abandon its crisis policies.
The continuation of the mild tone by the US monetary authorities should open the way for another impulse to strengthen emerging market currencies. Today's session is twice as important for the ruble, which has been gaining sharply over the past month. The summit between the presidents of the US and Russia in Geneva could be a milestone on the way to resolving geopolitical risks. In our opinion, the room for strengthening has mainly been exhausted after the recent rally of the Russian currency, which was supported by the boom in energy commodity markets.
Dollar vulnerable to Fed's communications puzzle
The US Federal Reserve has two equal tasks: to make sure inflation doesn't get out of control and achieve full employment. The labour market has been a top priority over the past few months. Thanks to the progress of vaccination and the prospect of easing tightening combined with powerful fiscal stimulus, the prevailing view was that employment could rebound in the spring at a rate of about one million jobs per month. Nothing of the sort. Demand for labour is powerful, with vacancies exceeding 9 million, the highest ever. Yet employment is rebounding slowly, partly due to crisis-era social transfers. This complicates the assessment of this crucial sphere of the economy for the Fed. Still, the most likely scenario assumes an acceleration of its recovery in the second part of the year. Currently, the labour force stands at 145 million people, which is still about 5% lower than before the pandemic.
At the same time, the Fed stuck to the interpretation that the jump in prices is temporary, but this position is increasingly disputable. In May, US consumer prices were as much as 5% higher than a year ago. Such strong price pressures in the US economy have not been seen since 2008. High readings are clearly influenced by statistical base effects, one-off disruptions caused by the pandemic and the lifting of restrictions, such as sharply rising prices of used cars, higher hotel rates and airline ticket costs. But upward pressure on prices is evident in a growing number of categories of goods and services. The combination of an increasing likelihood that inflation will not start to slow and weaker (for whatever reason) employment recovery is a tough nut to crack for the Federal Reserve.
The dollar exchange rate must wait for monetary support
Everything is about how and when to start cutting off the monetary support to the economy coming out of the collapse. The market will look for clues in the statement, new forecasts, and Jerome Powell's conference that an exit strategy discussion is beginning. Asset purchases continue at a pace of 120 billion USD per month. Extremely mild central bank policy is the foundation upon which the pandemic rally in equity and commodity markets is built. A potential turn in attitude and signalling that abandonment of crisis policies is imminent could trigger a strong reshuffle in the Treasury bond market and pull the dollar out of trouble. In 2013, in a similar situation, the Fed's careless communication caused shock and panic, with capital flowing out of emerging economies in a wide stream. This time the topic has been rolled out for months, so the reaction should be calmer.
There is no doubt that the Fed will make a shift in attitude at some point. However, for the time being, it should remain faithful to the current rhetoric. In fact, only time can unequivocally disprove the thesis that the pick-up in inflation is temporary. This means that the dollar (in an environment of strong global economic growth and loose financial conditions) should remain weak in the next six months. At some point, there will be a vision of policy normalization on the horizon. For example, it will be faster than in the eurozone (just as growth in the US will be faster). Such disparities result in the strongest trends in currency pair quotations. In this case, however, it is probably the perspective of 2022. We maintain our forecast that at the end of the year, the EUR/USD will reach 1.24, and the dollar index will be clearly under 88.00.