FX Update: Scenarios for the FOMC, ECB and BoJ.

Today's Saxo Market Call podcast

FX Trading focus:

• Scenarios for what each of the major central banks meetings will deliver and how the market may reach, starting with
• UK labor market data comes in strong, with sharply improved revisions of key April numbers.

FOMC meeting – a likely pause, but there is a big “but”
The FOMC is likely to deliver a pause today, but if it does want to hike once more, it will more likely be today than in July, whereas the market is pricing low odds of a hike today and slightly better than 50/50 odds of a hike in July. The three most likely scenarios are arguably no hikes at either meeting, a, hike today but none in July, or hikes both today and in July. It makes little sense from a credibility angle to pause for one meeting only – if the Fed is going to pause and then resume hiking, it would likely pause at least for a couple of meetings before resuming further down the line because, for example, inflation remains sticky rather than continuing its fall.

One thing to observe of late, and especially yesterday, is that the market is rapidly unwinding its pricing of eventual Fed rate cuts for the end of this year and particularly for next year. The December meeting is now on par with the current policy rate, while the June 2024 SOFR interest rate future has unwound a chunky 100 basis points of easing expectations over the last month. Part of this could be a side effect of recent strong risk sentiment, but in that case, the longer end of the yield curve will be in danger of breaking higher and eventually pushing back against that same sentiment melt-up. I am less curious about the Fed’s decision to hike or pause today and more curious about how the market prices the Fed next year and whether the long end US treasury yields are set for a rise through 4.00%

In short, some scenarios for the Fed:
Highest probability: Fed does not hike, but emphasizes its intent to keep rates high for longer than previously with an upgrade of the 2024 Fed funds projections in the “dot plot” (most dots clustered in the 4-4.5% range) and perhaps with some marginal upgrades in the economic forecast for this year, particularly the unemployment rate. The market reaction function? If this feeds the recent melt-up in sentiment and doesn’t see US treasury yields rising aggressively, the US dollar may weaken against pro-cyclical currencies especially, but also broadly. If US treasury yields rise sharply on the back side of the meeting, presumably because the Fed manages to get across a more hawkish message on rates staying high for much longer, it could spook risk sentiment and send the USD higher, especially versus EUR and JPY, but also broadly. In general, the 10-year yield bears watching as a key risk factor for global market

Somewhat lower probability: The Fed hikes but signals something resembling the above in its guidance (a likely pause but wants to reserve ability to tighten again at some point down the road). No material reaction difference beyond a possible very large knee-jerk USD rally.

Lowest probability: Fed hikes and makes it clear it is leaning for another move in July. Far more USD bullish unless the market reads this as the Fed determined to trigger a recession and long US treasury yields fall.

Wild card: Fed Chair Powell mentions the stock market/financial conditions in the press conference Q&A and concerns that it could drive instability.

ECB can ease up on weak economy, downside inflation misses.
The ECB is likely to provide less drama than the Fed as weak growth data and the latest Eurozone inflation data undershooting (core for May estimated at 5.3% versus 5.5% expected and 5.6% in April, with the May headline number down to 6.1 vs 6.3% estimated, 7.0% in April, and a peak of 10.7% (!) last year) help to simplify its task. The ECB can deliver the expected 25 basis point hike and downshift the forward guidance slightly, indicating a bias for a further hike but no urgency, given softening inflation. Also note that the ECB will allow almost half a trillion of TLTRO bank loans to roll off later this month, with Italian and Greek banks in the spotlight on that issue. No reason to expect any shift in the hawkish direction, rather more likely to be in-line with expectations.

ECB scenario: There is little anticipation of this meeting driving volatility, as measured by EURUSD implied volatility in 1-month options, for example, dropping over the last week to below 6.5% and the lowest since February. Assumption is that the ECB delivers the expected 25 basis point hike, and alludes to further tightening bias with no urgency. This keeps the euro neutral to possibly weaker against the broader market, depending especially on whether the FOMC manages to drive USD strength or weakness. Market reaction function: the “surprise side” is a more dovish than expected outcome, with the extent of that reaction depending on whether the BoJ or more likely the FOMC manage to surprise in the opposite direction. Risk off and higher US treasury yields on the Fed managing a hawkish surprise would likely see EURUSD pushing for the 200-day moving average below 1.0550, while a Fed that fails to impress and an in-line ECB could allow EURUSD to dribble higher toward 1.1000 (but Euro not notably strong elsewhere).

Bank of Japan: most ability to surprise, but the least propensity?
At Kazuo Ueda’s first meeting as Bank of Japan Governor back in late April, the bank announced the intent to conduct a policy review of up to 18 months before making decisions. If the bank remains good on its word, it is only likely to tweak policy before April of next year or later (after the latest yearly wage talks in March) if the yen is coming under significant pressure due to pressure from global yields continuing to rise, for example on an improvement in the economic growth outlook, and/or on a fresh spike in energy prices. Market measures of anticipation coming into this meeting (options skew, options implied volatility, etc.) suggest declining anticipation of anything happening on Friday. The irony there is that the surprise factor is that much bigger if the BoJ delivers a surprise tweak or guidance for a tweak soon. The BoJ delivering absolutely nothing could keep the "pain trade" of further steady weakening of the JPY alive.

BoJ scenario: market anticipation of something material developing at this meeting is virtually nil, so any actual tweak or flagging of a tweak at coming meetings would be a significant shock initially, with the JPY’s ability to continue strengthening dependent on what yields are doing globally, as discussed in the chart below. If the BoJ delivers nothing and US longer-end treasury yields head higher, regardless of what the FOMC delivers, USDJPY could head to new local highs here – to 142+ initially. If US yields head lower (not sure how we get there, given wild risk appetite and coming treasury issuance) or the BoJ surprises with a policy tweak, USDJPY could be in for a downside correction - needing to take out 137.00-137.50 to suggest a significant reversal.

Chart: USDJPY vs. US 10-year Treasury yield
The peak in USDJPY above 150.00 last fall coincided with the peak in US 10-year treasury yields, with a significant intervention around that time frame after an earlier one in September when USDJPY reached 145 for the first time since the 1990’s. The turn in US rates lower was more important than BoJ intervention. Since then, the subsequent peak in early March may have been more muted due to anticipation that the Bank of Japan under new leadership would tweak policy further after the December move to expand the cap on the 10-year JGB yield to 0.50% from 0.25%. USDJPY could arguable go back to test 145+ and even 150 again if US 10-year treasury yields shift higher and challenge the 4.00% level unless the Bank of Japan makes a credible threat to begin tightening.