FX Daily: As Hawkish As It Gets

The dollar can count on a stronger floor after the Fed raised rates and signalled another hike is likely by year-end. EUR/USD downside risks remain, with oil prices and risk sentiment in the driver’s seat. The Bank of England should keep rates on hold today and can err on the dovish side with communication. A BoJ hike tomorrow may not help the yen structurally.

The dollar rallied across the board following Wednesday's Fed hike.

USD: On a structurally stronger position

Everything about yesterday’s FOMC meeting was hawkish. The widely expected 25bp hike was accompanied by a dot plot showing strong consensus for another hike this year. Out of 18, 12 members project one more increase and four project two more this year. Incidentally, growth and inflation projections were revised higher and unemployment lower. Chair Kevin Warsh didn’t give much away in the press conference, but reiterated a strong commitment to price stability and didn’t seem to indicate that policy is restrictive at current levels. In his own words, the Fed simply reduced a “dose of accommodation”.

Despite hawkish pre-meeting bets, all of that still triggered a 10-12bp jump in the two-year USD swap rate. Market pricing for October is 13bp and for December 32bp.

The dollar rallied across the board, with DXY up 0.6% and at a two-month high. We think risks are more balanced for USD now that the monetary policy boost has been absorbed, but they remain tilted to the upside in the near term. First, because such a hawkish message means – in our view – markets are given the freedom to fully price in October for the next move should data come in hot and/or oil prices rise further. Second, because the pledge of monetary discipline raises the bar for a return of the debasement trade. Third, because oil prices still make for a supportive external environment for the dollar.

Our baseline call for the coming months remains one of stabilisation around current ranges first and a softer dollar then into year-end, but is heavily reliant on a de-escalation in the Gulf. As long as oil remains supported, it’s hard to argue against the bullish USD momentum.

This morning, Asian G10 currencies are leading a small rebound, primarily driven by a recovery in US equity futures. The yen has behaved better than other low-yielders after the Fed hike, suggesting some reluctance to add JPY shorts to tomorrow’s Bank of Japan decision. As we discuss in our preview, the bar for a hawkish surprise there is fairly high – even more so after the Fed’s message. Our baseline remains for USD/JPY to find support above 155 and stabilise around 156-157 in the coming weeks.

EUR: Short-term fair value plummeting

We expected a hawkish Fed could take us to 1.150, but the meeting exceeded our expectations and prompted a big break lower in EUR/USD. The two-year swap rate differential widened by 15bp to the widest since July, when EUR/USD was exploring sub-1.14 levels.

Surely, the ECB’s own hawkish message is offering better support to the euro, but oil prices are much higher than two months ago. Our model now shows a short-term fair value at 1.150, 1% lower than a week ago.

Further moves in front-end rates, oil or global equities can quickly push that fair value lower. So downside risks persist, and there is little (especially eurozone-born) – outside of a correction in energy prices – that is likely to turn the tide for EURUSD at this stage. There is, incidentally, no strong technical support in sight before the 1.132-1.135 area, which marked the bottom of the summer.

GBP: BoE a laggard in a hawkish world

We expect the Bank of England to leave rates unchanged at 3.75% today, with another 6-3 vote split, fully in line with consensus. Pricing is only 2bp for today, but 41bp by year-end and 93 by July 2027.

While three members are likely to continue voting for a hike, we see little evidence that the six doves are moving in that direction. In fact, several policymakers have become increasingly confident that the latest energy shock will not generate the sort of second-round inflation effects seen in 2022, a view that was broadly endorsed by August’s CPI report.

The main question for the meeting is therefore not whether the hawks will keep calling for tighter policy, but whether Governor Andrew Bailey signals any discomfort with market pricing.

We expect these dovish risks to feed into a weaker sterling against the dollar and the euro. EUR/GBP remains our preferred way to play that GBP weakness beyond the near term, and we target 0.87 by year-end.

CEE: Dollar strength keeps regional currencies under pressure for longer

Yesterday’s Fed meeting was clearly negative for emerging markets. A stronger US dollar is likely to keep weighing on EM currencies, outweighing the late-session decline in gas prices and leaving the overall balance tilted to the downside. We therefore expect further weakness across CEE and have become more bearish on the region over the medium term. With no sign of an imminent easing in the US-Iran conflict or a sustained fall in global energy prices, CEE currencies are likely to remain under pressure until regional central banks begin hiking rates or geopolitical risks subside.

After yesterday’s EUR/PLN spike, which far exceeded our bear expectations, the zloty may stabilise before the pair moves higher again. EUR/HUF appears more vulnerable, with current global conditions leaving room for further upside ahead of next week’s NBH meeting. A hawkish decision, such as pausing rate cuts and lowering the inflation target, could, however, offer some support to the forint.

Today, attention turns to the CNB meeting, where rates are expected to remain unchanged at 3.75%. Although conditions across CEE have shifted markedly in recent days, we expect the CNB to wait before changing its tone. The outcome is therefore likely to be dovish relative to market pricing, which currently implies more than four rate hikes. EUR/CZK enters the meeting just above 24.300, in line with the expectations in our CNB preview published last week. A dovish message, combined with adverse global factors, should push the pair higher and could take it above 24.350 today.