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.
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.