The Federal Reserve has started to increase interest rates and has signalled that there are many more to come in the next couple of years. However, despite this, the USD is starting to turn corrective. With expectations baked in, this could be the start of a move to reverse some of the long-held dollar strength.
- The FOMC has hiked by +25bps and signalled further tightening with another 6 hikes potentially this year.
- However, it could be that markets now start to be priced for perfection, where it has been to buy on rumour, sell on fact.
A hawkish hike from the Fed
With inflation surging close to 8% on the headline CPI, the Federal Reserve has moved to act. Recent acceleration of the taper of asset purchases, and now the first rate hike in three years.
A +25 basis points hike to +0.50% has been broadly expected since the Russian invasion of Ukraine. The prior talk had been of potentially a +50bps hike but given the uncertainties of the economic impact of the war, most FOMC voters went for +25bps. Only James Bullard (consistently the most hawkish member on the committee) voted for 50bps.
See the statement from the FOMC below. The red lines are the changes from the previous meeting.
There were three key takeaways from the statement:
- The war will increase inflation and weigh on growth (no surprise)
- The balance sheet will begin to be reduced at a “coming meeting”
- Bullard dissents – looking for +50bps
The economic projections were an interesting read. The FOMC has dramatically cut its expectation for growth in 2022, from 4.0% in December, down to 2.8% now. The primary factor is the impact of the war, but also the continued high levels of inflation would be weighing on growth expectations too.
The continued flattening of the US Treasury yield curve reflects this, where the spread between shorter-dated yields (such as the 2 years) and longer-dated yields (such as the 10 years) are coming ever closer to zero (currently just 0.21%). This reflects the short term impact of raised interest rates, before the hit to the economy in the longer term.
We also note the sharp increase in the projection of the Fed Funds rate for this year and 2023. This is reflected in the infamous “dot plots”. What is interesting is that a further six interest rate hikes are expected this year, and another four next year. Below we see a graphic (from ING) that reflects this. The median level of the dots reflects the projections of interest rates from the Fed. There seems to be a big gap between market expectations and Fed projections.
All priced in, for now?
Market expectations are not budging on interest rates in the wake of this Fed meeting. As we see on US interest rate futures, the rate hikes are currently priced for this year and in 2023 before the rate cuts start coming in 2024. Note the big inversion of the curve. Furthermore, the yellow line shows today’s pricing and the purple for yesterday. This fall today suggests that traders are looking at this and thinking that the Fed is unlikely to achieve its projected hikes.
The big gap between the Fed and the market is interesting. Historically, the Fed tends to be behind the market. This poses a question of whether the Fed is too aggressive in its projections, which will subsequently need to be re-aligned lower.
Perhaps there is a degree of caution surrounding the war in Ukraine which is hampering the market. If (and hopefully when) the war comes to some sort of peaceful resolution, there may be a repricing for the market. However, it would appear that the economic consequences of the Fed’s aggressive tightening would appear to show the need for rate cuts to come in again once inflation has been moderated.
This could be one of the reasons why the US dollar (USD) is starting to correct in the wake of the Fed.
USD outlook in the coming weeks
We have seen the Dollar Index rallying significantly since the middle of 2021, with a huge bull run that has moved DXY from 89.5 towards 99.4. Pricing in the rate tightening has been crucial, whilst the recent weeks have seen an acceleration higher on the back of haven demand from the war in Ukraine.
However, there is plenty of room for a near term unwind in the coming weeks, with the uptrend coming in around 96.00. A prospective peace agreement could be the next big mover on the USD, but that could take several weeks. The next meeting of the FOMC is in six weeks. Again, how the market reacts if there were to be a +50bps hike at the end of April would be another big gauge. However, for now, the market is moving on seemingly knowing the limit of the Fed’s tightening, and this move seems to be corrective.
EUR/USD is in near term recovery and the reaction around resistance at 1.1120 will be a key moment. If this can be decisively cleared then a continued recovery can be seen towards 1.12/1.13. Holding on to the support of a higher low in the recovery at 1.0900 will be important for this potential recovery.