FX Update: Three ways for FOMC to surprise hawkish even if data also critical

Today's Saxo Market Call podcast.
Today's Market Quick Take from the Saxo Strategy Team

FX Trading focus: FOMC: Powell set to push back against market’s complacent expectations, but will need to pull a big surprise to get respect unless data conveniently strong. SEK pain continues despite normally supportive backdrop – what gives?

Please refer to the FOMC, ECB and Bank of England previews in the latest excellent piece from Charu Chanana, our strategist in Singapore Charu. We are mostly on the same page and I don’t have much to add to her thoughts. One key consideration, however, both for what the Fed and Fed Chair Powell actually deliver today in the monetary policy statement and the press conference, is the quality of incoming data, not only the data this week, but the CPI data point on the 14^th. Yes, inflation has faded as a focus in the US with the recent couple of data points, but the new methodology, if it sees a far lower contribution from the largest and very badly lagging component of CPI, Owner Equivalent Rent, could see an even more rapid deceleration in CPI in the coming few months.

Until then, a hawkish Fed with upside surprise in earnings and payrolls and especially ISM Services that all combine to backup the Fed’s message are the most USD supportive (outside of real hawkish surprises as outlined below), while the least USD supportive is a monetary policy statement that still points to an imminent pause after a bit more hiking, followed by weak pushback with nothing to back it up from Fed Chair Powell, and then in-line to slightly weaker or much weaker data.

Outside of rhetorical protestations at the post-FOMC , the Fed can surprise on the hawkish side and reverse the aggressive easing in financial conditions in perhaps three ways, in relative order from most hawkish to less hawkish:

A large hike. The least likely surprise would be a larger than expected rate increase – 50 basis points or even something cheeky like a 37.5% hike to take the rate to 4.75%, abandoning the quarter point upper and lower bound silliness that is a relic of ZIRP days.

Something on the balance sheet. Somewhat hazy here, but if the Fed points to new ways that it will seek to adjust its balance sheet reduction to engineer longer rates higher to ensure tightening financial conditions, this could come as a significant surprise and could give risk assets a bloody nose and boost the greenback.

Refusing to guide for a pause and pointing explicitly to financial conditions as a factor in Fed decision to pause. This is perhaps the most likely course for the Fed to take to make its point, as it would force the market to recognize that as long as financial conditions are exceptionally easy, the Fed may continue hiking for now, only seen failing to do so if, for example, credit spreads were to tighten and financial conditions likewise as weak data points to a sharply weakening economy.

Chart: GBPUSD
The GBPUSD rally found resistance near the prior major high near 1.2450 as it awaits the FOMC and BoE meetings today and tomorrow. Thoughts on the Fed above, but the Bank of England can surprise significantly today as well, with perhaps far more potential to do so on the dovish side, given the weak (if now less dire) outlook and stabilization of the currency in recent weeks and the huge drop in energy prices. The market is pricing the BoE to deliver about another 60 basis points of hiking beyond the 50 basis points expected tomorrow. While EU-US 2-year spreads are at a 15-month highs, the UK-US spread has eased lower since mid-December. The USD is likely in the driver’s seat as the prime mover, but BoE surprises could add some mustard to the move in either direction.