Rate hikes & FX: bigger, faster, longer... recession?
Ever since US inflation came in hot and the Fed surprisingly beefed up their rate hike to 75bps, there’s been a LOT of action and talk from central banks. With so much going on, it’s easy to lose track. Here’s a recap of what's going on under the hood of the major FX pairs and a look ahead at what might lie in store.
The Dollar (USD)
There were/are plenty of reasons to be long USD which has led to some resilient dollar strength over the past 12 months or so:
The yen and euro have been the biggest losers in this dollar strength environment, closely followed by the pound.
The dollar tends to be most in demand at times when the US economy outperforms, interest rate differentials widen (in favour of the US) or when recession hits.
The first two criteria have been key drivers of the trend, but there are signs that might be on the turn. Since the June 15th meeting, interest rate markets have repriced their expectations for future Fed rate hikes.
Comparing June 15th with June 24th we find that:
- The peak interest rate is now seen at 3.63% vs 4.21%
- Peak interest rates will be reached sooner February 2023 instead of May 2023
- The December 2022 rate is seen at 3.36% vs 3.6% which implies the market is pricing one less hike of 0.25% this year than pre-meeting.
All of which means the market sees higher odds that we are past ‘Peak Fed’ hawkishness and economic concerns will restrain the FOMC from being as aggressive as feared. This could lead to a narrowing of the interest rate differentials that had supported the dollar.
Thursday’s flash PMI readings from the US weren’t encouraging either. While still in growth territory above 50, the accompanying commentary & leading indicators portend economic fears becoming reality. Key snippets from the report:
“The pace of US economic growth has slowed sharply in June, with deteriorating forward-looking indicators setting the scene for an economic contraction in the third quarter”
- “... the goods-producing sector [is] already in decline and the vast service sector [is] slowing sharply.
- “...services firms are now seeing households increasingly struggle with the rising cost of living, with producers of non-essential goods seeing a similar drop in orders.”
- “...a remarkable drop in demand for goods and services during June compared to prior months”
- “Business confidence is now at a level which would typically herald an economic downturn, adding to the risk of recession.”
- “A corollary of the drop in demand was less pressure on prices, with the survey’s inflation gauges for firms’ costs and their selling prices falling sharply in June to suggest that, although still elevated, price pressures have peaked.”
The Federal Reserve won’t mind that last point. The whole point of tightening financial conditions is to bring inflation under control. The rest of the report is concerning to say the least.
We could perhaps see a situation where the dollar weakens as other central banks ‘catch up’, only to give way to dollar strength again as fears rise, or if a crisis hits.
The Yen (USDJPY)
This pair’s really been the big story of the year so far. Fed hikes have strongly favoured the USD as the Bank of Japan has resolutely refused to budge from their low rates policy.
Core inflation has now (just) surpassed the BoJ’s target of 2% for the second straight month, but sluggish wage growth is still concerning the central bank. Unless domestic demand strengthens and wage growth really improves, the BoJ is unlikely to move.
Much of the rise has also been driven by the terms of trade. Japan’s a major energy importer. The recent downticks in USDJPY have coincided with drops in oil and the US 10 year yield. If these trends continue it could lead to some JPY strength and a lower USDJPY.
The Euro (EURUSD)
Where to begin with the eurozone? Challenges galore! The economic ‘weaponisation’ of Russian gas supplies led Germany’s economy minister to warn of “...a Lehman effect in the energy system.” On top of that, the ECB are trying to respond to inflation by increasing interest rates while simultaneously battling ‘fragmentation’ risks.
Although eurozone economies share a currency, their debt/bonds trade at different prices. If this pricing diverges and gets too extreme, the transmission of monetary policy can become ineffective. The ECB have promised to devise a tool to combat this, but details are very light so far.
And so, the euro has arrested the decline for now with a double bottom at the 1.0350 area.
But it’s really hard to confidently forecast a sustained euro rally until/unless some of these risks are definitively dealt with. Interest rate markets currently price 152bps of hikes by the end of 2022.
The British Pound (GBPUSD)
“It’s forecast to have weaker growth, higher inflation, and a bigger current-account deficit than the US, euro zone or Japan next year, not so much a trilemma as a tragedy.” - Kit Juckes (Societe Generale)
The veteran strategist summed the mood up well with his comments to Bloomberg. The UK is in the midst of an identity crisis in a post-Brexit, post Covid world. However, there could be progress on the horizon. In July, Chancellor Sunak is expected to announce the Financial Services and Markets Bill, which is anticipated to remove EU red tape, remove regulatory burdens and release funds from insurance firms for investment.
However, the Bank of England has been a reluctant hiker so far, even with the highest inflation rate (9.1% in May) among G7 nations. BOE’s MPC member Mann expressed concern about importing inflation via a weaker GBP in a recent speech. Stronger messaging from the Bank, perhaps even an inter-meeting hike could shock GBP into strength.
The Australian Dollar (AUDUSD)
Heavily influenced by commodity demand, the aussie’s taken a hit in recent weeks, as commodity prices have begun to roll over. Concerns over China’s economy and high stockpiles of iron ore have also weighed on the prospects for AUD upside.
If global slowdown fears do materialise, commodity prices could fall further and drag the aussie lower too.
However, the pair has managed to put in a sequence of higher lows on the daily chart, and the promise of 50bps rate hikes at upcoming meetings from RBA governor Lowe could be supportive.
The Canadian Dollar (USDCAD)
"We know inflation is keeping Canadians up at night. It's keeping us up at night," - Bank of Canada Senior Deputy Governor Carolyn Rogers this week, after inflation hit 7.7%.
A 75bps hike seems likely at the next meeting. She followed up by saying
"The balance of risks are very much tilted to the upside on inflation. So right now, the way we're looking at this is, the most important thing is to get inflation back to target,"
For now, USDCAD is compressing in a sequence of lower highs and higher lows. CAD bulls (USDCAD bears) will want to see a clean break below 1.29 and then eye a test of the 20 day moving average just below 1.28…
The Swiss Franc (USDCHF)
The Swiss National Bank shocked everybody with a 50bps rate hike at the recent meeting, causing a swift move in all CHF pairs as the Franc strengthened.
See, the Swiss central bank only meets once per quarter, and with domestic inflation ticking higher they felt the need to act decisively. Governor Jordan cautioned that further rate hikes may be necessary to tame inflation too, so that’s the metric to watch. If inflation marches higher, markets won’t rule out the possibility of an inter-meeting hike either.
Whatever happens, volatility looks set to continue. We’re a LONG way from the tame FX markets of a few years ago.
Not investment advice. Past performance does not guarantee or predict future performance.