The subtle hint from the Federal Reserve regarding tapering was not enough to derail markets, and with improving sentiment towards China, this suggests near-term respite for cyclical FX. We favor currencies backed by hawkish central banks: CAD, NZD, NOK in the G10 FX space and BRL, MXN and RUB in emerging markets.
USD: Fed hints at taper, but cautiously
Although the FOMC made more hints at the upcoming QE tapering, the impact on the risk sentiment was limited and non-negative as the message remained cautious, and QE tapering later this year has been widely expected by the markets (UUP).
As per our FOMC Review, our economists expect QE tapering to be formally announced in December, looking for the relatively swift reduction that sees QE purchases end in the second quarter of 2022 and two interest rate increases in 2H22. Particularly on the tapering side, the start of the process in December should not be perceived as aggressive. It should keep risk sentiment supported for the time being, particularly after the news that the Chinese regulator tried to ease global investors’ concerns about the latest regulatory crackdown. The stabilizing risk environment should allow local stories to play out, and currencies backed by hawkish central banks - CAD, NZD, NOK in the G10 FX space, BRL, MXN, and RUB in emerging markets should outperform.
EUR: The euro to remain the laggard
While the initial reaction to the July FOMC was modestly softer USD and higher EUR/USD, we expect EUR to be the laggard among G10 currencies (along with JPY and CHF) as low yielders with dovish central banks (the euro and the ECB tick the box here) should not enjoy much of a boost from the cautious Fed. This is because the Fed will eventually be ahead of the ECB in normalizing policy, particularly next year – when the Fed fully ends QE and starts hiking. The bar remains high for EUR/USD to persistently and meaningfully break above the 1.2000 level (FXE).
It is a busy day on the domestic data front in Sweden, with the July economic Tendency Survey and Q2 GDP releases. The data should have a very limited impact on SEK given the Riksbank stubbornness about its cautious approach and signaling no change in interest rates over the forecast horizon. Rather the slow grind in EUR/SEK lower should be primarily driven by the stabilizing risk sentiment.
GBP: Room to re-build sterling longs
Sterling continues to reap the benefits of the slowdown in Covid-19 cases, in turn reversing the prior market concerns about another meaningful wave. This means a further adjustment in the GBP speculative positioning lower is unlikely. Rather, there is a room to re-build sterling longs after their meaningful decline over the past few months (FXB).
Data-wise, June UK consumer credit and June mortgage approvals shouldn’t affect GBP in any meaningful way today.
CAD: Easing inflationary pressures unlikely to impact BoC’s tapering plans
Canada’s headline inflation faced a slowdown (from 3.6% to 3.1% YoY) in June. That is probably a welcome development by the Bank of Canada as it supports the central bank's view that inflation spikes will have a transitory nature. That said, it will hardly impact the BoC’s tapering plans, in our view. After all, the jobs market has proven to be very strong in the recovery and core inflation was broadly unchanged (and above target) from May to June.
We remain of the view that the BoC will end asset purchases by the end of 2021 and that the case for the first hike in 2022 is getting stronger. From an FX perspective, we think that the central bank's hawkishness can help CAD outperform once market sentiment improves and investors find fresh interest in entering reflationary/carry trades (FXC).
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