Head of FX Strategy
Summary: The market was forced to price in higher potential rates from the Fed in coming months after hawkish comments in the Powell press conference yesterday, in which it was clear that the Fed wants to provide as little specific guidance as possible, but that is does not want to exclude anything and that there is “quite a bit of room to raise interest rates without threatening the labor market”. This is a sea change in Fed behaviour since Bernanke invented the policy of explicit forward guidance nearly 15 years ago.
FX Trading focus: Fed maintains hawkish credibility
Yesterday, I mostly laid out the case that the USD might head tactically higher if the market was expecting a dovish Fed and that the Fed would like to stay on the established message without sending any dramatic new signals, certainly not on the dovish side. The new monetary policy statement contained about as few changes as possible and was fully in line with existing expectations for a wind-down of QE purchases by the March FOMC meeting. It would have been more hawkish to see the Fed halt its purchases immediately, but perhaps the Fed wanted to avoid any sense of panic. A March rate hike was clearly flagged as the Fed added language that it would be “soon” to raise interest rates. In addition, the Fed released a separate statement entitled Principles for Reducing the Size of the Federal Reserve's Balance Sheet that flagged an intent, much discussed by other Fed officials in recent weeks, to reduce the balance sheet, even if there were few details beyond an indication that tightening would occur after rate lift-off and that maintaining treasury holdings would be prioritized. The short statement also emphasized that rate rises were seen as the primary Fed tool for tightening policy.
It was in the press conference, however, that the hawkish surprises unfolded. Powell was generally cagey in providing any guidance on how much the Fed would hike or the schedule for quantitative tightening. But when one reported asked whether the Fed might hike at consecutive meetings, Powell refused to answer the question directly, but did say that there is “quite a bit of room to raise interest rates without threatening the labor market.” Toward the end of the press conference he even said that
The lack of clear guidance is likely behind the USD,Fed rate expectations and US yields rocketing higher during and in the wake of Powell’s presser, with the September EuroDollar future adding nearly 20 basis points of hikes to expectations by year-end (a full 110+ basis points of hikes in 2022 now priced), while the entire yield curve lifted, perhaps on the fear that quantitative tightening will also lift longer rates. The US 10-year Treasury yield benchmark is some 8 basis points higher this morning, only a few basis points from the cycle highs. Takeaways are tricky, but clearly the Fed wants to avoid boxing itself into forward guidance that it will then have to trip over – perhaps in either direction. It suggests that the Fed is humble after it so badly anticipated both the inflationary spike and the tight labor market and that it would like to maintain credibility, especially to the upside on where it might take rates. The market was forced to respond with a far wider cone of uncertainty.
Chart: EURUSD
EURUSD was sent tumbling as the market felt forced to price in the risk of more Fed hikes this year than originally anticipated and as the entire US yield curve lifted in the wake of the FOMC meeting and Powell presser. Noises from the key ECB governing council members continue to suggest that the ECB will be slow to adjust policy on the belief that inflation will prove transitory, meanwhile. The price action took EURUSD back below 1.1200 by this morning, just a few pips from the cycle low back in November of 1.1186, a break of which would likely shift the focus to the 1.1000 area. Eventually, if central bank expectations continue to generally rise, a capitulation from the ECB on the need to guide for rate hikes could prove a watershed moment that supports the Euro, but this moment has not yet arrived. We won’t necessarily see runaway downside here if longer US yields remain anchored – and somewhere out there in the mists of time, either Fed tightening will crash markets or that ECB shift will arrive.
The Bank of Canada meeting was a somewhat different affair yesterday as the Bank neglected to hike rates as expected, although future expectations remained steady as this was used as a “setup meeting” for future rate moves. The Canadian dollar was sharply lower versus the US dollar, though most of that was down to the market response to the FOMC meeting as CAD was fairly firm in the crosses. The Bank of Canada did issue a new statement indicatingan end toits “exceptional forward guidance” and expressing the belief that "overall economic slack is now absorbed”. After a brief dip in forward rate expectations, short yields rose again to more or less unchanged as this statement was seen as providing no change to the Bank’s intent to eventually hike rates even more quickly than the Fed this year – even after the reaction to last night’s FOMC meeting in US yields. Nonetheless, BoC governor Tiff Macklem waxed cautious on the short-term macroeconomic outlook: “Reopening the economy has proven complicated (…) We are going to learn more about Omicron in the coming weeks”. The downgraded its GDP forecast for 2022 to 4.6 % from 5.1 %.
Table: FX Board of G10 and CNH trend evolution and strength.
The massive shift in the USD already in evidence after last night’s FOMC meeting despite the “smoothing” of the trend measure. Even the renminbi bowed before the greenback’s strength yesterday. Note USDJPY pulling sharply higher this morning as yields stayed elevated while risk appetite has managed to stabilize.
Table: FX Board Trend Scoreboard for individual pairs.
Here we see USDJPY, USDCHF and USDCAD flipping positive. Hard to believe that the CNHJPY positive flip is set to show legs, as the value mismatch there is reaching remarkable extremes.
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