Market Skepticism Persists as Hawkish Narrative Faces Challenges: FX Daily Analysis

FX Daily: Hard times to sell a hawkish narrative

The Fed paused yesterday but signalled two more hikes in its dot plot. Markets, however, are not trusting the new projections, and barely price in one more 25bp increase to the peak, likely due to recent softish inflation figures. The ECB won’t have an easier task selling such hawkish rhetoric today, and EUR/USD faces some moderate downside risks.

 

USD: Dollar bulls can cling on to the dot plot

The Federal Reserve matched market expectations for a hold yesterday, but definitely surprised on the hawkish side with its messaging. As discussed in our Fed review note, the FOMC retained maximum flexibility as it signalled openness to further rate increases: the updated dot plot rate projections were reviewed considerably higher from March, and the median projection now includes two more rate hikes in 2023, before 100bp of cuts in 2024. Remember that the March dot plot signalled we had reached the end of the tightening cycle, now only two FOMC members see rates being held at 5.25% until year-end.

 

The dollar had come into the FOMC announcement with a bearish tone, as PPI figures released yesterday morning showed more encouraging signs of a slowdown in inflation and prompted markets to fully price out a rate hike later in the day.

 

Despite the hawkish surprise contained in the Fed message – primarily in the dot plot – the dollar failed to rebound. That is because there was an evident dislocation between the Fed’s hawkish signals and the market reaction: investors are carefully weighing the evidence of slowing inflation from the CPI and PPI data, and appear – so far – reluctant to align with the Fed’s projections. The Fed funds futures curve prices in 17bp of tightening for July, and 22bp to the peak.

 

The post-FOMC pricing is telling us that markets accord higher credibility to data than the Fed’s communication, so more evidence of US disinflation/economic slowdown can prompt more dollar weakness moving ahead. However, with markets underpricing rate hikes compared to the dot plot, we’d be cautious before jumping on a bearish dollar trend just yet, given the high risk of market pricing converging to the Fed’s projections and pushing short-term swap rates higher again.

 

So, dollar bulls can probably cling on to the hawkish dot plot for now, or at least until (and if) data indicates more unequivocally that there is no longer a necessity to raise rates.

 

This morning, we are seeing the dollar recovering some ground, although that appears to be primarily driven by the weak activity data out of China and fresh rate cuts by the People's Bank of China.