FX Outlook: Five Central Banks that Matter – Updates & Expectations

Here are five central banks that matter the most to global financial markets. Although each enacts economic and monetary policies to support their respective economies and financial systems/markets, they communicate with each other regularly and, on occasion, coordinate policies in the interests of global stability and growth.

1. BANK OF CANADA (BoC) – more hawkish

Last meeting’s results: On April 13, the BoC hiked its target for the overnight rate by 50 bps to 1.00%, as expected. It was the biggest rate increase since May 2020. The BoC vowed more rate hikes to restrain soaring inflation partly driven by the war in Ukraine. The BoC also said it would continue to shrink its balance sheet over time by ending its bond buying program on April 25th and not replacing maturing Canadian government bonds.¹

Current situation: The BoC is pressured to aggressively hike rates to address:

1. rising inflation – the BoC said in its April Monetary Policy Report that CPI inflation is expected to average almost 6% in H1, up from its January forecast of 5%, adding that it could be 2024 before CPI returns to its 2% target, and
2. a tight labor market – unemployment fell last month to 5.3%, its lowest-ever level. The BoC said it expects that “robust business investment, labor productivity growth and higher immigration will add to the economy’s productive capacity.”²

Expected changes in monetary policy: Using rates on overnight index swaps as a guide, traders predict BoC will hike rates seven times in 2022, ending the year with a benchmark rate of 2.65%.³
Next meeting: June 1, 2022.

Currency hedging opportunities. Buyers of forward CAD are positioned reasonably well, since the USD/CAD forward point adjustment has turned positive and nears its highest level since 2015, and the USD/CAD continues to trade in a wide 1.2450 – 1.2850 range in place since July 2021.

2. U.S. FEDERAL RESERVE (the “Fed”) – more hawkish

Last meeting’s results: On March 16, Fed officials reached consensus on reducing the Fed’s balance sheet by $95 billion per month, beginning in May. The Fed also approved its first rate hike in over three years -- the 25 bp hike raised the benchmark short-term borrowing rate from near zero, where it’s been since March 2020. Some Fed members argued for a 50 bp hike, but the war in Ukraine likely kept it to only 25 bps.⁴

Current situation: The Fed is clearly focused on inflation, as it sharply raised its outlook, while lowering economic growth expectations. Highly regarded analyst Mohammed El-Erian said in a recent CNBC interview that “inflation will not peak anytime soon and the surging prices could force the Fed to raise its target.” ⁵

Expected change in monetary policy: Traders are re-pricing expected Fed rate hikes following yesterday’s speech by Fed St. Louis President James Bullard. Bullard effectively confirmed a 50 bp rate hike in May but did not rule out the possibility of a 75 bp hike.⁶ Traders now expect 9 hikes this year, with a 2.5% rate at year-end.⁷
Next meeting: May 3-4, 2022.

3. EUROPEAN CENTRAL BANK (ECB) – less hawkish

Last meeting’s results: On April 14, the ECB gave no clear date for its first interest rate hike. ECB President Lagarde said the bank would raise rates “sometime after” eliminating pandemic stimulus efforts. That could mean “anywhere between a week to several months,” while sticking to a gradual path despite expected aggressive tightening by the Federal Reserve and other major central banks to curtail soaring inflation.⁸

Current situation: A combination of factors is influencing ECB decision-making:

1. the weak euro, as a result of the widening gap in US-EZ interest rates in favor of US and expectations it will likely continue;
2. slow manufacturing and service PMIs and GDP growth;
3. rising inflation – last month’s rate of 7.5% YoY in the eurozone is the highest in over 20 years;⁹ and
4. growing concern with the economic/political impact from Ukraine-Russian war. These factors argue against any sudden, near-term recovery in the euro.

Expected change in monetary policy: Last week’s ECB meeting fell short of the market’s more hawkish expectations, which forced a re-pricing of ECB expected ECB rate hikes. Traders trimmed rate-hike bets following the meeting but are still pricing in 25 bp hikes in September and December that would bring the deposit rate up from -0.50% to zero.¹⁰
Next meeting: June 9, 2022.

Currency hedging opportunities. Buyers of forward EUR are positioned well since EUR/USD trades solidly within a long-term downtrend. However, strong support lies with the 1.06-1.08 range, which suggests buying some EUR within that range. The forward points have increased, making hedging slightly more expensive than earlier in the year.

4. BANK OF ENGLAND (BoE) – moderately hawkish

Last meeting’s results: On March 16, the BoE hiked its Bank Rate by 25 bps, returning to its pre-pandemic level of 0.75%. This was the third consecutive meeting resulting in a rate hike. The BoE stated that it raised rates again in an attempt to prevent entrenchment of fast-rising inflation but drew back on the need for further increases as households face soaring energy prices and businesses face supply chain issues related to the Ukraine war.¹¹

Current situation: The UK’s economy is slowing more sharply than expected: UK monthly GDP growth was just 0.1% in February, below 0.3% expected, and down from 0.8% in January; Retail Sales unexpectedly fell 0.3% in February; although Services PMI in March soared to its highest level in 12 months, Manufacturing PMI fell to its lowest level over the same period; and, CPI inflation in March increased to 1.1% over February, its highest rate of inflation in five months, and core inflation ex-energy and food increased 5.7% YoY in March, its highest rate in 25 years.¹²

Expected change in monetary policy: Using rates on overnight index swaps as a guide, traders expect at least 5 rate hikes over the remainder of 2022, ending the year with a benchmark rate of 2.00%¹³
Next meeting: May 5, 2022.

Currency hedging opportunities. Buyers of forward GBP are positioned well since the GBP/USD downtrend remains strongly intact. However, the $1.30 level has become strong support, so some hedging around that level may be in order. Forward points for GBP/USD are fairly flat for trades maturing this year, but increasingly expensive next year.

5. BANK OF JAPAN (BoJ) – still dovish

Last meeting’s results: On March 18, the BoJ remained a dove by keeping its short-term policy rate unchanged at -0.10%, and vowed to purchase enough Japanese government bonds to cap the 10-year yield at around 0.00% (then, on March 31, it raised that level to 0.25%).¹⁴

Current situation: Japan has weak economic fundamentals: GDP Q4 QoQ of 0.4% -- the weakest in the G-10; Balance of Trade in deficit for seven straight months; Retail Sales for February declined by 0.8% MoM; Industrial Production for February rose 0.1% MoM, its first rise in three months. CPI inflation for February at 0.9% YoY is the lowest in the G-10.¹⁵ The yen has collapsed over the last six weeks – from ¥114 to nearly ¥127 per US dollar – pushing import prices higher and damaging Japanese corporate and global investor sentiment, which is putting pressure on the BoJ to take steps to slow/reverse the upward trend in the USD/JPY.

Expected change in monetary policy: Using rates on overnight index swaps as a guide, traders expect no change in short-term rates for the remainder of 2022, and one 15 bp hike in the second half of 2023.¹⁶
Next meeting: April 28, 2022.

Currency hedging opportunities. Buyers of forward JPY are positioned extremely well since the USD/JPY has moved dramatically higher over the last six weeks. However, USD/JPY forward points have moved significantly more negative, so buyers of yen will see an increase in hedging costs.

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