Post date: 24/10/2022
There is definitely a feel in FX markets that the dollar rally has run its course for now. US Treasury yields and Fed expectations rose to fresh record highs, but the dollar failed to benefit and in fact ended the week down against every other G10 currency. International interest rates now track US ones fairly closely and markets are perhaps coming to the conclusion that they have overestimated the chances of an energy crunch in Europe, which makes it tough going for a very expensive greenback. Special mention to our old favourite the Brazilian real, the week’s strongest currency, and also the best performer of the year.
This week the key ECB meeting for October takes place on Thursday. Another huge 75bp hike is expected by markets, the consensus of strategists, and ourselves, but the key to the market reaction should be President Lagarde’s communications at the press conference. The flash PMIs of business activity on Monday in the US, Eurozone and the UK will compete with the ECB meeting for the spotlight. The key PCE inflation report in the US will close out a busy week on Friday. This is perhaps the inflation number that the Federal Reserve pays the most attention to.
As stability is restored to Gilt markets following Liz Truss’ resignation, sterling is tentatively finding its footing after an extremely challenging month. News on Sunday that Boris Johnson was giving up on the leadership contest, and thus opening the way for Rishi Sunak, seemed to cheer investors on early Monday trading in Asia, lending further support to the pound. The biggest downside risks seem to have been removed for now, and the key is the Bank of England’s reaction at its next meeting in early November. A 100bp hike would dispel any further notions that UK authorities intend to inflate their way out of trouble and be a significant positive for the pound. This may, however, be a rather high bar to hurdle.
This week is shaping up to be a critical one for the common currency. In addition to the ECB meeting on Thursday, the PMIs are published on Monday. Expectations are fairly pessimistic, for a move further down in contractionary territory. However, recent pullbacks on energy prices and the extremely generous state support packages for households and businesses that have been announced could set up markets for a positive surprise. As for the ECB, in addition to the expected 75bp hike, we may get further clarity from Lagarde on what the central bank expects its terminal rate to be. Current market pricing has that well below 3%, which stirks us unrealistically low. As expectations move towards a more reasonable level, the euro could gain some support.
Market expectations for the Federal Reserve’s terminal rate of interest, i.e. the level at which it expects to at least pause the hiking cycle, finally breached the 5% level last week, in spite of a dearth of macroeconomic news. Daly and Evans were the first Fed official to speak after this psychological level had been breached, and he seemed to suggest that it was high enough or perhaps even a bit too high for their taste. The next milestone for this unprecedented hiking cycle will be the release of the Personal Consumer Expenditures inflation report on Friday. All eyes are on the core number for the month, where an unacceptably high annualised level of near 6% is expected. A downward surprise here could have a disproportionate negative impact on the US dollar, given the consensus and market positioning for an ever-stronger US dollar.