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The Fed paused yesterday but signaled two more hikes in its dot plot. Markets, however, are not trusting the new projections, and barely price in one more 25bp increase to the peak, likely due to recent softish inflation figures. The ECB won’t have an easier task selling such hawkish rhetoric today, and EUR/USD faces some moderate downside risks.
 

USD: Dollar bulls can cling to the dot plot

The Federal Reserve matched market expectations for a hold yesterday, but definitely surprised on the hawkish side with its messaging. As discussed in our Fed review note, the FOMC retained maximum flexibility as it signaled openness to further rate increases: the updated dot plot rate projections were reviewed considerably higher from March, and the median projection now includes two more rate hikes in 2023, before 100bp of cuts in 2024. Remember that the March dot plot signaled we had reached the end of the tightening cycle, now only two FOMC members see rates being held at 5.25% until year-end.

The dollar had come into the FOMC announcement with a bearish tone, as PPI figures released yesterday morning showed more encouraging signs of a slowdown in inflation and prompted markets to fully price out a rate hike later in the day. Despite the hawkish surprise contained in the Fed message – primarily in the dot plot – the dollar failed to rebound. That is because there was an evident dislocation between the Fed’s hawkish signals and the market reaction: investors are carefully weighing the evidence of slowing inflation from the CPI and PPI data, and appear – so far – reluctant to align with the Fed’s projections. The Fed funds futures curve prices in 17bp of tightening for July, and 22bp to the peak.

The post-FOMC pricing is telling us that markets accord higher credibility to data than the Fed’s communication, so more evidence of US disinflation/economic slowdown can prompt more dollar weakness moving ahead. However, with markets underpricing rate hikes compared to the dot plot, we’d be cautious before jumping on a bearish dollar trend just yet, given the high risk of market pricing converging to the Fed’s projections and pushing short-term swap rates higher again. So, dollar bulls can probably cling on to the hawkish dot plot for now, or at least until (and if) data indicates more unequivocally that there is no longer a necessity to raise rates.

This morning, we are seeing the dollar recovering some ground, although that appears to be primarily driven by the weak activity data out of China and fresh rate cuts by the People's Bank of China.
 

EUR: No easy task for Lagarde today

It’s European Central Bank decision day, and our call for a 25bp rate hike is fully in line with consensus and market expectations. In our ECB Cheat Sheet, we outline four different scenarios along with implications for EUR rates and EUR/USD: in our base case, today’s rate increase will be paired with an attempt to convey a hawkish tone and leave the door open for more tightening ahead.

Markets are almost fully pricing in another hike in July, and the focus will primarily be on President Christine Lagarde’s press conference and whether she will offer hints that the Governing Council is leaning in favor of a July move. Staff projections will also be released but may not gather enough attention or drive much market reaction.

Given the market's strong conviction about another 25bp hike in July (or September at the latest), the bar for a hawkish surprise is probably set quite high today. The ECB may need to signal several more hikes to trigger a significant jump in the euro and that does not look very likely considering the recent signs of decelerating inflation and deteriorating growth outlook. In other words, there is still the interest for the ECB to sound hawkish today, but we suspect that might not be enough to send the euro higher, and we see some moderate downside risks for EUR/USD today.

We could see EUR/USD drop back to the 1.0750 handle today, although developments on the US data side will continue to drive the large majority of trends in the pair moving ahead, with ECB policy playing second fiddle, in our view.
 

GBP: Staying supported into the BoE meeting

We are entering a few days of calm in the UK calendar after a slew of key data releases. Yesterday’s GDP data endorsed the recent re-rating of the UK’s growth outlook but hardly mattered for the Bank of England as much as the inflationary signals sent from the jobs and wage growth figures earlier this week.

Bank of England rate expectations were marginally scaled back after the Fed meeting, but still imply five 25bp rate increases from current levels before the end of the year. It’s important to note how the higher gilt rates are by themselves starting to have their tightening effect on the economy. Mortgage market distress is the most direct example, with major lenders hiking rates and some pulling mortgage offers following the recent repricing of tightening expectations.

It is, still, too early to factor that – or any implications for the housing market – into sterling, which will probably continue to find support into next week’s CPI and Bank of England meeting. EUR/GBP could move closer to the 0.8500 key support after today’s ECB decision.
 

JPY: It’s a “skip” from the BoJ too

We don’t expect real surprises from the Bank of Japan policy announcement overnight. We recently withdrew our views on the adjustment of the yield curve control policy in June, following some firmly dovish comments by BoJ officials. Still, with little-to-nothing being priced in terms of a hawkish surprise, the downside risks for JPY also appear limited.

Our economics team continues to see good chances that the BoJ will make some changes to its YCC policy at the end of July – although the Fed decisions will admittedly play an important role. Incidentally, further USD/JPY strength (possibly driven by carry trade strategies) may well lead Japanese authorities to restart FX intervention, which was deployed around the 145 area last September. We may not be far from the peak in USD/JPY, even though a reversal of the bullish trend may take some time.

Elsewhere in G10, we saw New Zealand enter a recession after a 0.1% contraction in 1Q, with the impact of Cyclone Gabrielle having impacted activity without causing a material jump in inflation (which surprised the downside in 1Q). It remains to be seen whether the government’s spending boost will prevent the recession from proving to be the norm for the rest of the year. For now, the figures all but endorse the recent dovish turn by the Reserve Bank of New Zealand, and a repricing higher in NZD rates looks unlikely before the 12 July policy meeting.

Australia’s May jobs numbers moved diametrically in the opposite direction than the April release, showing a huge increase in hiring (75.9k) almost entirely driven by full-time employment (61.7k). The unemployment rate inched lower to 3.6%, and markets now fully price in two more rate hikes by the Reserve Bank of Australia. The Australian yield curve inverted for the first time since 2008 after the release, as 2-year yields jumped 10bp. Although this is a sign of a coming recession, a domestic inverted yield curve is not a bad sign for a currency in the near term: the question is whether the RBA will match the hawkish market expectations on tightening. We are not fully convinced as inflation may prove less resilient than markets are thinking, but AUD understandably remains one of the pro-cyclicals of choice at the moment.

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