DB FX Daily: The Fed, G10 Carry and the USD

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FX Daily: The Fed, G10 Carry and the USD

The Fed, G10 Carry and the USD

The Fed surprised markets yesterday by removing its tightening bias, but maintained that "the predominant policy concern remains the risk that inflation will fail to moderate as expected". The initial reaction to the statement was market-friendly, with US yields falling, equity markets rallying and credit spreads tightening, while EUR/USD briefly traded above 1.34. Inflation expectations as measured by 10-yr TIPS breakeven rates widened, perhaps reflecting concerns that the Fed's inflation bias has softened. What does this mean for the USD and the G10 carry outlook more generally?

At first sight, the change in Fed stance appears to bode well for risky assets such as the G10 carry trade, which are likely to take note of the Fed's apparent willingness to underwrite US growth, moving closer to neutral despite the still elevated inflation numbers. We would however be more cautious. The change in the FOMC language may be reflecting increasing concerns that the US growth outlook has deteriorated, but without a corresponding improvement in the inflation picture. Such a cyclical outlook would post significant hurdles to the performance of carry trades going forward, should the growth outlook continue to deteriorate but inflation pressures persist.

In terms of the outlook for the USD, an initial rebound in carry trades may mean that dollar bears looking for immediate weakness in the FOMC aftermath will be disappointed. The dollar remains a high-yielding currency and is likely to remain on the sidelines should carry trade performance persist. Looking further ahead however, the risks may be tilted towards a shift in focus back towards the broader dollar trend. The worsening cyclical outlook, as reflected in both a steepening yield curve and widening inflation breakevens (see charts below), are likely to pose significant hurdles to a recovery in the USD any time soon.