FX Daily: Fed's Hawkish Hold Sets a Floor for the Dollar and Anticipates Tightening Ahead

FX Daily: Fed's hawkish hold can put a floor under the dollar

We expect the Fed to hold today but signal more tightening is possible. The endorsement of market pricing for future hikes can ultimately keep the dollar around strong levels for a bit longer. We expect EUR/USD to end the week closer to 1.0700 than 1.0800 when also factoring in the ECB meeting. In Sweden, an inflation surprise may bode well for a SEK recovery.

 

USD: Small deviations in core inflation can have huge implications

Yesterday’s CPI numbers in the US had the potential of being the biggest risk event for markets this week, but May’s figures ultimately came in very close to consensus expectations: core inflation moved by 0.4% month-on-month (5.3% YoY, slightly above expectations), while the headline rate decelerated to 4.0%, a touch more than expected. On balance, Fed fund future pricing tells us that markets saw the release as slightly dovish, and the implied probability of a rate hike today was trimmed to 12% from 23% pre-CPI.

 

The dollar is trading moderately weaker into the FOMC day, with the post-CPI reaction in the currency market seemingly following a risk-on, European-rotation rationale: the high-beta NOK and SEK shone, while the yen dropped yesterday. USD/JPY is dangerously close to the 140.90 30 May high, which would leave the yen vulnerable to a move to 145 area, where Japanese authorities started to intervene last September.

 

The Bank of Japan announces policy on Friday, and the response that we are seeing in the FX market is probably a testament that market expectations for possible policy adjustments are rapidly disappearing at this Friday's meeting.

 

Our original call for today’s Fed announcement was a hawkish hold, and yesterday’s deceleration in inflation gave us no reason to review it. Our economist discusses here why the latest CPI read could mean we are indeed at the peak of the Fed’s rate cycle, while here is our scenario analysis for today’s FOMC policy announcement.

 

Despite the welcome developments in inflation, the Fed wants to see a 0.2% MoM or below CPI readings to feel confident inflation will return to target, and this is why we think today’s statement will include a quite explicit openness to further tightening in the future, which could be expressed via the wording “future increases may be appropriate”.

 

 

While our base case is that Dot Plot projections will be kept unchanged, it is surely possible that the committee will add another hike to the 2023 median forecast. The Dot Plot can really swing the balance for the dollar reaction: we think signalling another hike in the 2023 projections would trigger a quite substantial dollar rally as markets see the July meeting as the most likely date for the next rate increase.

 

We don’t see negative implications for the dollar in our baseline scenario (hawkish messaging, unchanged median Dot Plot), as the endorsement of the market’s hawkish repricing of Fed expectations should keep the recent bullish narrative for the dollar alive for a bit longer: that is until data takes a decisive turn for the worse in the US.