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FX Update: FOMC kneejerk fading fast.

Forex 5 minutes to read
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John Hardy

Head of FX Strategy

Summary:  The kneejerk to the FOMC meeting was a weaker US dollar and rally in risk sentiment, as the market felt the FOMC delivered little relative to expectations, though the kneejerk has faded sharply in Europe today. Powell made it clear that the Fed does not want to provide explicit forward guidance on rate moves from here and will yielding to incoming data, which will aggravate volatility around key data releases.


FX Trading focus: FOMC kneejerk fading fast

The FOMC meeting was an interesting test of market psychology as the statement and Fed Chair Powell refused to deliver much, leaving the market to its own devices – having to decide whether its own expectations on where the economy will be by late this year and into next year are correct and whether the incoming data in that period will see the Fed able to slow its rate tightening and then even begin to cut already starting perhaps by mid-year next year. The market puffed out its chest with confidence late yesterday that Fed Chair Powell had not pushed back strongly enough on the market forecast, but seems to be second-guessing the knee-jerk reaction by lunch-time in Europe today.

My initial reaction to the FOMC meeting in an internal memo just after the conclusion of the presser last night was as follows:

The FOMC statement provided very little to go on – really only the addition at the beginning of the statement that “Recent indicators of spending and production have softened. Nonetheless.. [repeats strong labor market views, etc.]”

In the Q&A, Fed Chair Powell dodged every attempt to make a point that could be considered solid forward guidance – he even specifically stated that the Fed won’t issue any “clear guidance” on future rate moves and that the June FOMC rate forecasts are the only thing on offer for a likely path of rates (even after WSJ’s Timiraos specifically poked Powell to answer whether he thought it was fair that the market is pricing the Fed to cut rates next year after a peak by the end of this year.) For the September FOMC meeting, Powell said that further “unusually large” rate increases (read: 75 bps vs. 50 bps) will depend on incoming data, with two CPI prints before that September 21 meeting. Market currently priced at +58 bps.

The general lay of the land is this: Fed sees some evidence of heat coming out of the economy, but refuses to provide new guidance and will be ruled by the data – this will mean extreme sensitivity to US data releases from here (the stronger the US economy and/or inflation the worse for the market)

The initial market reaction is that this has sparked aggressive risk-on as it solidifies the market confidence in its own forecast: that inflation is set to recede and growth slow, allowing the Fed to peak out with the Fed funds are about 100 basis points higher still, but rolling over to cuts on a weak economy/recession next year.

We consider this path highly unlikely, and the significant easing of credit spreads and fall in yields all along the curve since mid-June (timing of prior FOMC meeting) will likely mean risks of higher inflationary readings from here. The Fed is asleep at the wheel….and we don’t trust the initial market reaction, even if it could extend in the very short term (if at all beyond today’s session – big earnings could be negative distraction as market essentially got what it wanted – permission to indulge in its own forecast of how the economy will shape up, with Fed not leading, but reacting.

We have to remember as well, that Fed will mechanically begin reducing liquidity via QT as it moves toward peak pace of $95 billion of balance sheet reduction per month by September (maximum achieved so far only $35 billion reduction over last four weeks) and that August is traditionally a poor month for liquidity….

The action in Europe by late this morning is already casting a shadow over the kneejerk reaction to the FOMC meeting, for EURUSD in particular, with the broader USD picture quite mixed since yesterday. Given the dismal reality facing the EU heading into the fall, I have a hard time supporting the euro in any currency pairing. Note EURNOK slamming lower as it should, given Norway’s total insulation from the energy woes (I do wonder about how Norway deals with the PR long term of the kinds of incredible profits it is reaping from this situation). I can’t see why EURNOK shouldn’t fall to 9.50 and even 9.00 eventually on a miserable winter situation for power/gas prices in Europe in coming months. EURJPY looks heavy, too, which it should be, given the tremendous tightening of yield spreads and the ugly overhang of economic and semi-existential (Italian populist uprising redux at coming election) angst. On the latter, noting the 136.87 area. Elsewhere, the USD reaction has not faded as much – still need to give ourselves through tomorrow’s close (post-PCE inflation data) for a sense on whether the market got this FOMC reaction “right” for a larger move.

Chart: EURJPY
EURJPY is nearing critical technical levels as the euro is the sick currency of the world at the moment, stealing the JPY’s recent thunder as the easing in bond yields globally, and especially in Europe, has the negative attention slowly pivoting away from Japan (note tonight sees July Tokyo CPI out of Japan). A drop through the 136.87 level could quickly open up for a test toward the 133.00 area noted and last test in May and even 130.00 eventually if the news flow doesn’t improve for Europe.

28_07_2022_JJH_Update_01
Source: Saxo Group

Table: FX Board of G10 and CNH trend evolution and strength.
Euro weakness deepening here, while we still hold our breath a bit on USD direction until the Friday close. NOK leads the pack for good reason as oil and gas prices are both resurgent, while AUD is a strong runner-up on that gas prices, but also as industrial metals are a bit resurgent and coking coal is on a tear.

28_07_2022_JJH_Update_02
Source: Bloomberg and Saxo Group

Table: FX Board Trend Scoreboard for individual pairs.
EURNOK is dropping like a stone and EURSEK is mulling the 200-day moving average break (recently, I have argued that SEK may break its slavish correlation to simple risk sentiment). The USDJPY has flipped negative as of the current print – let’s see if that move sticks through the weekly close. EURGBP is powering lower, but I am reluctant to get on board the recent flip of GBPUSD to a rising trend.

28_07_2022_JJH_Update_03
Source: Bloomberg and Saxo Group

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