Credit: 
The forex market has been trying to trade on monetary policy divergence for so long that it has felt like a never ending story. Well, both the ECB and Fed have taken steps in the opposite directions over the past week that has put monetary divergence back in the forefront of the forex market.
As I noted in my article, Is a Firm US Dollar a Deterrent to a Fed Rate Liftoff?, the Fed has to weigh the impact of a strong dollar in its monetary policy decision, especially after the ECB sent a signal that it might ease at its December meeting. Well, the Fed showed little concern over the exchange rate by coming across more hawkish than expected, including removing recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term from its statement. This was taken as a sign that a December rate hike is back on the table as suggested by inserting the words "next meeting" in the statement:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
Monetary Policy Divergence and the Dollar
With the ECB sending a signal for monetary ease and the Fed raising the risk for a rate liftoff sooner rather than later, monetary policy divergence is likely to dominate forex trading ahead of respective central bank meetings in December. Ahead of this is the Bank of Japan policy board meeting on Friday, which is seen as a close call whether it eases policy.
In any case, the Fed, seeing its credibility being challenged, has taken control of the debate by raising the risk of a December rate. This should keep the market in a data dependent mode although the Fed seems to have lowered the bar to liftoff.
What this means for the dollar is that it will be trading on monetary policy expectations. With these expectations diverging, the dollar should be supported as long as EURUSD trades below 1.10 and USDJPY above 120. This does not mean that it will be a one way street but only that the risk is on the dollar upside while below/above these levels.
Looking ahead, with two parts to the diverging monetary policy equation, only a shift in sentiment on either side would alter the dollar risk. In this regard, watch the next two US employment reports and inflation indicators, the latter facing the strong dollar as a headwind to higher prices, as the Fed appears to be looking for reasons to hike rates.
Jay Meisler, founder
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
