European currencies are fighting back against the dollar this week as investors start to speculate on early ECB tightening. We will hear from the ECB today and be interested to see whether we get much of a 'rate protest'. We should also see a 25bp hike from the BoE and a 75bp hike from the Czech National Bank. The dollar could stay under a little pressure.
USD: Temporary soft patch
It was always going to be a tough week for those bullish on the dollar and so it has proved with the DXY now 1.3% off last week's high and unwinding most of last week's gains. Softer US data this week - including an ADP jobs release pointing to a negative January NFP tomorrow - has slowed the Fed tightening story. But the bigger challenge to the dollar has come from overseas, particularly in Europe. Stubbornly high inflation here is prompting a re-assessment of the amount of patience the likes of the ECB can show. And the re-pricing of the ECB cycle is providing support to European currencies in general.
It also seems that more central bankers are embracing one of the key themes we have been discussing over recent months - the preference for strong currencies. This theme ran through our January FX Talking 'Competitive Revaluations'. Yesterday National Bank of Poland Governor, Adam Glapinski, said he welcomed the stronger Polish zloty. This is from a central bank that not so long ago was intervening to buy EUR/PLN under 4.50.
So far the ECB has yet to embrace the need for a stronger currency. And our core story, certainly for the first half of this year, is that the large positive output gap run by the US, compared to the negative output gap seen in Europe, makes the threat of higher US rates much more credible and pressing than it is for the eurozone. That is why we expect the dollar to stay bid on dips against European currencies and probably make some marginal new highs into spring/summer.
Photo by Sharon McCutcheon on Unsplash
Elsewhere, we note with interest another 150bp hike in Brazil, but communication that the pace of adjustment will slow. The policy rate is now 10.75% there and could edge up to 12.00% this summer. But expect to hear a lot more about bond investors gaining interest in EM local currency bonds now that the end of tightening cycles is approaching for some. 10 year Brazilian sovereign local currency debt yields are 11% and FX hedging is highly unlikely given the policy rate up here. Long carry trade interest in BRL could pick up, but the election year in Brazil makes this a high reward-high risk proposition.
Today will be all about rate meetings in Europe. A softer US ISM services index looks unlikely to move the dollar. DXY could dip to the 95.70 area should Christine Lagarde not find the right words to downplay expectations of a 2022 ECB rate hike.
EUR: Will we see much of a rate protest from the ECB?
Two-year US-Germany sovereign yield spreads have narrowed 20bp from their peak of 180bp in late January - largely on the view that the ECB will not stand idle with CPI now above 5% in January. Recall that January was meant to see CPI dip as the Jan 21 German VAT hike fell out in the base effect. High inflation has seen the market push ahead with its pricing of the ECB tightening cycle. The market now prices a 10bp hike in the -0.50% deposit rate in July. And a full 25bp hike by the December meeting.
Market pricing places President Lagarde in a tricky position. Does she repeat her views that a 2022 rate hike is unlikely - and look blind to current price developments. Or does she somehow leave the door open for a December hike - which could see tightening expectations (probably more in 2023 now) extend? There is also the issue of sequencing, where the first rate hike currently is not considered until net securities purchases have ended. PEPP ends in March and currently, APP is intended to continue to year-end. Any further changes here look unlikely before the March meeting and the new forecast round. We outline some key variables and EUR/USD in our ECB crib sheet here.
On balance, we think President Lagarde will walk the tightrope of market expectations by sticking to the December staff forecasts, which suggested the need for a 2022 rate hike was unlikely. Is that enough to put the genie of 2022 ECB tightening back in the bottle? Unclear. But we suspect any EUR/USD spike to the 1.1360/1380 region proves temporary and would still favour a move to 1.10 into Spring.
GBP: The heat is on
Of the four scenarios James Smith outlines in his BoE preview, the baseline view assumes an 8-1 vote for a 25bp rate hike - taking the Bank Rate to 0.50%. We are also interested in the BoE's inflation report and its forecast as to whether CPI is on target in two years' time using the market's very aggressive pricing (1.50% Bank Rate early next year) into account. This is where the BoE would have an opportunity to present a rate protest.
Yet we doubt the BoE is unhappy with the aggressive market pricing given that it is generating a strong pound. Also, today expect much local focus on the energy regulator announcing the size of the regulated energy price increases for April. This will add to the view that UK inflation is heading close to 7% YoY in April - and that a strong pound can insulate against further energy price increases.
With the BoE in dynamic tightening mode (and well ahead of the ECB), expect EUR/GBP to trade down to 0.8300.
CZK: 5.00% rates here we come
The Czech National Bank (CNB) announces its interest rate decision at 1430CET and follows up with a press conference at 1545CET. It will also release its Winter forecast update. The last forecast update had CPI peaking around 6.5% in early 2022 with the rate cycle peaking around 3.5%. December 21 CPI has already come in at 6.6% YoY and the policy rate is already at 3.75%!
Most are expecting a 75bp hike today to take the policy rate to 4.50%. Hawks at the CNB have already been briefing the press that this cycle should not go above 5% - thus it would be quite a hawkish surprise were 5%+ policy rates to be shown in the CNB's forecast today. How high could the CPI forecast be revised? To 7, 8% or higher? And the market will be interested to look at the CNB's expected profile for EUR/CZK. Back in November the CNB was forecasting that EUR/CZK would be trading towards the low 24s through 2022 - and here we are today! Will this forecast now pencil in substantially sub 24 levels for later in the year?
The CZK has been a solid EMFX performer this year and we cannot see any major reasons for a big sell-off today. Interestingly, Polish NBP Governor Glapinski explicitly welcomed Zloty strength yesterday and joins the CNB - who have been welcoming CZK strength since it fired up its tightening cycle last summer.
With: i) EUR/USD enjoying new-found support from the ECB (a steady/higher EUR/USD typically sees CE3 currencies out-perform), ii) the CZK now seriously interesting for FX reserve managers with 4%+ rates and iii) probably renewed foreign interest in Czech government bonds as we approach the top of the tightening cycle, EUR/CZK looks firmly on course to 24.00.
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