FX Weekly: The Federal Reserve continues to pursue aggressive policy tightening

Fed Monetary Policy Watch:

• US Federal Reserve raised rates 75 bps (3-3.25%) as expected by the market and remains committed to bringing inflation down to its 2% target rate with forward projections showing a potential terminal federal funds rate of between 4.5 - 5% by end of 2023.
• Core consumer price and payroll data will be key indicators to Fed policymakers as perceived rising price inflation combined with rising payrolls increases the risk of ‘entrenched’ inflation (stagflation).
• The Fed seems to be distancing itself from the promise of a ‘soft-landing’ as a ‘restrictive’ policy may be the only way to dampen inflation, however, leaving the door open to “assess how [their] cumulative policy adjustments are affecting the economy and inflation”.
• Fed rate hikes continue to create large fluctuations in currencies and push the dollar to new highs. Currencies should continue to see elevated levels of volatility as both risk and interest rate sensitive assets.

Market Bias: Bearish

• The Bank of England voted on raising rates 0.50% to 2.25%, a dovish outcome which put further downward pressure on the pound.
• There are concerns mounting that Prime Minister Liz Truss’s plan to stimulate the economy through a combination of tax cuts and energy price caps could create higher inflation and counter efforts by the central bank.
• The tax cut was also perceived by markets as a potential abandonment of fiscal responsibility, at a time when it is becoming more expensive to fund deficits. Initial reaction to the news was bearish overall.
• Risk to current market bias: Energy prices continue to descend while UK stockpiles remain healthy ahead of winter season. Supply chains loosen, and inflation cools faster than central banks anticipate.

Market Bias: Bearish

• The EUR continues to fall in the face of a more hawkish Fed policy path compared to the European Central Bank (ECB) policy. The EU faces higher risk of a deep recession and sovereign debt crisis potentially limiting how aggressively the ECB can lift rates.
• Eurozone Composite, Service, and Manufacturing Purchase Managers’ Index (PMI) all fell from prior levels now well below the 50-level signaling the EU is facing an economic contraction.
• Eurozone Consumer Confidence dropped to a new low of -28.8.
• EU members are nearing approval of additional sanctions including a price cap on Russian energy. This has gained momentum after Putin’s ‘partial mobilization’ in the war with Ukraine. However, there are doubts on the effectiveness of such a policy.
• Risk to current market bias: Energy prices continue to descend while EU stockpiles remain healthy ahead of winter season. Supply chains loosen, and inflation cools faster than central banks anticipate.

Market Bias: Bearish

• Canadian retails sales in July disappointed with month over month sales down 2.5% versus a forecasted contraction of 2.0%.   
• August year over year Consumer Price Index dropped below survey at 7% with core inflation cooling off which should give the Bank of Canada confidence in its interest rate policy is effective.
• Markets are anticipating a 0.50% hike at the Bank of Canada’s decision next month, and another 0.25% increase in December.
• Risk to current market bias: Supply chains loosen, and inflation cools allowing the Fed to moderate its rate hikes.

Market Bias: Bearish

• Japan intervened in the FX market for first time in over two decades, while keeping interest rates unchanged at -0.10% and the Yield Curve Control (YCC) in play. On the back of this, the yen strengthened 3.5%, however the currency quickly retreated.
• It’s doubtful that intervention will be effective as a standalone tool to control its currency depreciation as global central banks continue to lift rates and the Bank of Japan continues its policy to hold rates down.
• Earlier last week Japanese inflation hit a 30-year high presenting significant challenges to the central bank.
• Risk to current market bias: Continued Bank of Japan intervention could help keep the yen supported, however at a very steep cost.