Facing the Fed’s hawkish surprise as FX markets take off
By this stage we all know that the Federal Reserve meeting was more hawkish than expected, however, as we contemplate what this means for trading for the medium term, there are a few things that we need to consider.
Firstly, we will analyse what the higher than expected initial jobless claims in the US for last week will mean for markets in light of the latest information from the Fed.
Secondly, why Treasury yields have fallen since the Federal Reserve meeting, and lastly why the reaction in stock markets has also been muted. After weeks of subdued volatility, the FX community is hoping that this week’s Fed meeting will trigger larger moves in the G10 FX space over the coming weeks.
Could US growth disappoint?
While the market had an initial knee-jerk reaction to the Fed’s latest dot plot, which showed that most Fed officials now expect the first US rate rise to come in 2023, a year earlier than forecast a mere three months’ ago, the dust has now settled.
Now it’s time to analyse the economic data that will ultimately determine whether or not the Fed will act sooner than expected, and whether its talk of tapering is mere talk, or if it will lead to action in the coming months due to the strength of the US economic recovery. The US economy is set to grow this year by a whopping 7% this year, however there are increasing signs that growth will be front-loaded in Q1 and Q2, when the boost to consumer spending was at its peak after the US Treasury sent another round of stimulus cheques to tax payers.
Weak US retail sales for May highlights a shift away from online spending and towards spending on services and vacations. While the overall trend in retail sales remains strong, it could weaken as we progress through the summer months.
An unexpected rise in initial jobless claims for last week to 412k, from 375k the week prior, has added confusion to financial markets. Has the Fed started to talk tough on the need to reign in its extraordinarily generous monetary support at the same time as growth has peaked?
The Fed restores its credibility on inflation, without jolting markets
Right now, this confusion is playing out in the market as small losses for some major global stock markets and Treasury yields have fallen sharply. Considering this was the most hawkish message we have received from the Fed in more than 18 months, the reaction in Treasuries has wrong footed the market. The yield jumped from 1.54% prior to the Fed meeting, to 1.58% on Wednesday’s close, but 24 hours later it was trading well below 1.5%. The highs above 1.7% from Q1 seem like a distant memory. It would appear that the market was selling Treasuries (pushing yields higher) as US growth started to gather momentum earlier this year.
Now that the momentum is showing signs of slowing down, the upward pressure on Treasury yields (downward pressure on prices) has mellowed. We have mentioned in prior notes that there are signs that inflation pressures in the US may have peaked, for example, lumber prices are down more than 30%, the price of some metals are also lower and the oil price followed other commodities lower by the close on Thursday.
Taking a broad view, the Federal Reserve may have pulled off an impressive policy twist: managing to sound tough on inflation compared to previous meetings in order to protect its credibility, while at the same time Jerome Powell told the press conference to take the dot-plot with a pinch of salt because growth could weaken in the coming months. The Fed’s “hawkish” shock on Thursday might not be as hawkish as expected, for example, it has not caused disruptive price action in the markets and the papers are packed with stories about the Fed potentially tightening interest rates a year earlier than expected. Thus, the Fed’s credibility on inflation is restored.
The Fed, volatility and the dollar
Interestingly, while other markets have mostly brushed off the Fed meeting, the dollar is still rising and volatility in the FX market has inched up after being subdued for some time. The dollar is up across the board as the pound and euro sell off.
Emerging market currencies have also received a boost of volatility, with USD/MXN rising to its highest level since March, USD/TRY at a fresh all-time high, and USD/JPY also at its highest level for 3 months, although USD/JPY has eased off as Treasury yields fell sharply on Thursday.
The FX pair that is on our radar is EUR/USD, especially since it has fallen below $1.20. This is a key support level and opens the way to further losses. Other technical indicators are also pointing to further losses for this pair, for example, $1.1890-1.1910 is the 23.6% retracement of the March – Dec 2020 uptrend, if we get a significant decline below $1.19 then we may see a further decline to the more significant Fibonacci retracement zone at 38.2%, which comes in at $1.1650.
While other assert classes are ignoring the message from the Fed meeting, it is still a focus for the FX world. The contrasting inflation pictures for the US and Europe, along with the contrasting monetary policy paths, with the ECB very unlikely to tighten policy when the Fed does in 2023, also leads us to believe that there could be further declines in store for the euro.