It looks as if U.S. Dollar bears have a decision to make after the Fed Minutes painted a gloomy picture of the economy. Either the Dollar will decline because of the Fed’s outlook or the Dollar will rally because of renewed risk aversion.
For the past few weeks, worse-than-expected U.S. economic reports have driven investors out of the Dollar and into foreign currencies but this trend may be coming to an end as traders assess the Fed’s new outlook for the economy.
Late Wednesday the Dollar began a small comeback following the release of the June Federal Open Market Committee Minutes. In the report, Fed officials issued an updated economic forecast calling for a downward revision of the Gross Domestic Product. In April, the Fed pegged the GDP growth rate at 3.2 percent to 3.7 percent. Today’s report showed a downward revision of GDP to 3 percent to 3.5 percent.
The Fed also revised its forecast for the unemployment rate. The rate, now at 9.5 percent, is projected to drop to 9.2 percent in the best case scenario. In April, the Fed was calling for a decline to 9.1 percent.
Both downward projections paint a gloomy outlook for the economy, reflecting worries about how the European debt crisis could affect U.S. growth and job prospects. Traders have to remember that Europe is in the midst of invoking financial austerity measures which are designed to curtail spending. This could have a direct effect on demand for U.S. goods and services leading to a drop in GDP and lower employment.
Although the Fed is projecting a decline in GDP and employment, the Fed also saw less of a threat of inflation. The Fed predicted that inflation would rise 1 to 1.1 percent, down from the April forecast of 1.2 to 1.5 percent. This change in inflation reflects an expected drop in consumer spending.
Since the Fed is projecting low inflation, investors feel it now has room to leave interest rates at historically low levels for a prolonged period of time.
The key factors contributing to the decline in the economy are household and business uncertainty, weak real estate markets, a weak job market, diminishing fiscal stimulus and tight lending by banks.
Unlike April’s projections, this time “most” Fed officials felt that it would take “no more than five or six years” for the economy to reach its goals for maximum employment with low inflation. Previously, only a minority of Fed honchos thought it would take more than that time for the economy to recover.
U.S. Treasury markets rallied sharply higher following the release of the Fed minutes, indicating fixed income investors are looking for yields to fall further. This move could be indicative of the start of another flight rally into the Dollar.
With the Euro currently toying with a major 50% level at 1.2783, this spot on the chart would be the perfect spot for the start of a correction. Furthermore, with less than ten days until the release of the European bank stress test results and rumors afloat that eleven or more banks may have failed the test, now would be the right time for the Euro to begin to weaken.
Today’s Fed report may have taken the spotlight away from earnings season for the time being. A clash between those who want to sell the Dollar because of better than expected earnings and those who want to buy the Dollar because of renewed risk aversion may be on the horizon. This conflict between the two forces could trigger volatile conditions over the near-term with sudden shifts in direction. It’s hard to predict at this time which way the trend will develop, but what is clear is that traders are in for a rocky time in the markets over the short-run until one of the forces takes control.
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