FX Daily: Fed Rate Hike May Play Second Fiddle Amid Multiple Drivers

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We expect the Fed to hike by 25bp today and signal 90bp of extra tightening this year in its Dot Plot projections while acknowledging some degree of uncertainty related to the Ukraine conflict. The move is fully priced in and it might end up having a contained impact on FX, with peace talk optimism set to remain the primary driver. CPI in Canada may help CAD

USD: Not much support from FOMC announcement

Russia and Ukraine resume peace negotiations today, and despite the lack of any advancement in the latest talks, asset prices continue to price in a higher implied probability of an imminent de-escalation of military tensions. This is naturally translating into a weaker dollar, with the previously battered European currencies finding additional support. Also conspiring against the dollar has been a recovery in the Chinese yuan, which erased nearly all its losses since the start of the week on the back of reports that Saudi Arabia will consider accepting yuan payments for the crude it sells to China, and the People's Bank of China fixing USD/CNY in line with model-based expectations after two days where the pair was fixed higher. Tomorrow’s CNY fixing will be key to gauge how much the PBoC is determined to cap the yuan’s strength and potentially set the tone for Asia FX for the second half of the week.

In such a unique global environment, the impact of today’s FOMC rate announcement may not be straightforward. As discussed in our Fed preview, we expect a 25bp rate hike today, in line with recent communication by Fed Chair Jerome Powell and market expectations – which are only pricing in a 10% implied probability of a 50bp move. A lot of focus will also be on whether the Fed will hike the rates applied to reverse repos and excess reserves by the full 25bp or by a smaller amount.

What is set to drive most market reaction is the set of economic forecasts released with the statement today, and in particular the Dot Plot projections. We summarise our economic expectations in the table below.

Federal Reserve, ING 

We expect the median Dot Plot to signal 90bp of further tightening by the end of the year. While falling short of endorsing the more aggressive 150bp priced into the Fed funds futures market, we doubt it would cause a tangible dovish re-pricing, as markets may acknowledge a slightly more cautious approach by the Fed is caused by the high degree of uncertainty caused by the Russia-Ukraine conflict. This should also emerge in the statement/Powell’s tone at the press conference and in higher inflation/lower growth forecasts. Still, we expect Powell to reiterate the Fed’s commitment to fight inflation and to keep the overall policy message firmly on the hawkish side, despite the recent headwinds to growth.

Looking at the FX impact, we think the Fed message today should confirm that monetary policy is set to prove a medium-term positive for the dollar. That said, barring a major upside surprise in the Dot Plots, we suspect the post-FOMC impact on USD could prove rather contained and short-lived, leaving the dollar somewhat vulnerable to the current risk-on environment. It must be acknowledged, at the same time, that such a risk-on environment is mostly hanging on some optimism around peace talks and not on any actual de-escalation, and there is surely a risk that markets have moved too fast too soon towards the optimistic side of the spectrum. In summary, the dollar could struggle to recover today, but with a lot of optimism in the price, the risks appear tilted to the upside.

EUR: Looking for stabilisation above 1.10

EUR/USD remains solely driven by market sentiment around the Russia-Ukraine peace talks, as domestic factors yesterday (a sharp drop in the ZEW and ECB President Chrstine Lagarde’s reiteration of last week’s message) left no mark on the pair.

There are no market-moving data releases in the eurozone today, and – as discussed above – the post-FOMC FX impact might be limited, granting EUR/USD another attempt at a more decisive break above 1.100.  

Elsewhere in Europe, Sweden's krona remains the big outperformer this week, thanks to an improvement in the market’s perceived geopolitical sentiment and markets cementing bets on Riksbank tightening in 2022. This morning, Riksbank Governor Stefan Ingves gave an implicit nod to the recent hawkish re-pricing, by saying that he expects a rate hike before the forecast 2024. While still sounding very dovish on the face of it, the Bank’s previous reluctance to signal a hike before 2024 in spite of inflationary pressures encourages markets to over-interpret any tiny adjustment to the rate projections. Indeed, a hike in 2022 is no longer a remote possibility.  

GBP: Trailing in the recovery

There are no data releases in the UK calendar today and the pound should continue to find some modest support from the tentative optimism around military de-escalation in Ukraine. Interestingly, GBP is struggling to recoup the war-related losses, unlike other European currencies. This might be related to some wait-and-see approach ahead of tomorrow’s Bank of England meeting, where a rate hike combined with more hawkish language could allow the pound to play catch-up with the benign market environment and trigger some EUR/GBP weakness.

Barring a major upside surprise in the FOMC Dot Plots today, cable should hold above 1.3000 for another session.

CAD: More inflationary pressure in Canada

USD/CAD made a decisive break below 1.2800 yesterday, aided by some USD weakness but also signaling how the recent correction in oil prices is not enough to warrant material CAD weakness. After all, crude and other energy prices remain considerably more elevated than before the Ukraine conflict, and are indeed set to fuel further recovery in the Canadian oil and gas industry, which ultimately bodes well for CAD in the medium-term.

Today, we’ll see the February CPI report in Canada, with headline inflation that is expected to accelerate from 5.1% to 5.5%. We think this – along with the Fed’s start of the tightening cycle – should contribute to cementing the market’s expectations that the Bank of Canada will maintain a decent pace (five to six more hikes this year) in raising interest rates, which could endorse the loonie’s good momentum. USD/CAD to re-test 1.2700 today.