With four hikes priced in, the focus on the Fed balance sheet at Wednesday’s meeting could see the pricing of the Fed terminal rate stall or reverse, and the US dollar decline. Geopolitics will also remain central, with Russia-Ukraine tensions in focus. Expect to see Canadian dollar outperformance as the BoC hikes, while Italian politics may generate some jitters in the EUR/CHF pair.

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DXY: Correction May Have More to Run

The highlight of the week ahead will be Wednesday’s FOMC meeting, where our team expects the Fed to announce the end of QE prematurely and signal a readiness to hike in March. Given that four hikes are already priced in this year, the focus on the Fed balance sheet could see the pricing of the Fed terminal rate stall/marginally reverse and be mildly negative for the US dollar.

Additionally, next week sees a heavy slate of US tech, financial, and industrial Q4 earnings – leaving US equities in a vulnerable position as bond yields rise as well.

In terms of data, we’ll get our first look at Q4'21 US GDP data – expected near 5% quarter-over-quarter annualized after soft December figures. More important will be the Q4 Employment Cost Index on Friday. Any above-consensus figure could see the dollar end the week on a stronger footing on the view that second-round inflation effects were emerging in the labor market.

Geo-politics will also be present though the week, as Russia-Ukraine tensions continue. Any escalation should be a clear dollar positive – on the view that Europe’s dependence on Russia’s energy exports will be exposed even more.

EUR: Business Sentiment Under Scrutiny

A slightly softer dollar environment around the Fed could see EUR/USD pair trade up to the 1.1415/20 area, though we do not expect gains to last. Locally the week starts off with the release of January PMIs for the Eurozone, Germany, and France. Small declines are expected as the continent battles both the Omicron variant and higher energy prices.

Further insights into German business sentiment comes with the German Ifo. Notably, the ECB has also been sticking to its position that it does not need to follow the Fed with higher rates this year.

It is hard to see any real geo-political risk premium being priced into the euro yet. Yet undoubtedly the risks, including aggressive sanctions against Russia, would hit Europe’s growth projects far harder than those of the US – plus the spike in energy costs would hit the euro via the Terms of Trade channel. Elsewhere, the euro will keep on eye on political developments in Italy – see below.

JPY: Tug of War Between Higher Bond Yields and Lower Equities

The Japanese yen has been strengthening on the crosses as the global equity market correction gains traction. Somewhat surprisingly, Q4'21 US earnings have hit equity markets and more are to be released this week – especially some high-profile US tech stocks. The Japanese yen has consistently shown a negative correlation with US equities, and cross rates like AUD/JPY risk getting hit hard should equities extend losses. 

Developments in Japan have had little bearing on the yen for a long while now (including even BoJ view changes), but if the ultimate achievement of the Fed is to increase real US rates – plus allow energy prices to remain high – we would expect continued demand for USD/JPY on dips near 112.50.

GBP: Settling In

Market pricing of the BoE rate cycle has barely budged recently. Pricing a 25 bps hike at the Feb. 3 meeting remains around 90%, although the pound has given up some of its gains on the softer December retail sales data. Politics has yet to hit the pound on the view that even if PM Johnson were to resign, Chancellor Sunak would be seen as a safe pair of hands as an alternative.

For the week ahead, there may be some focus on UK-EC negotiations over Brexit – key officials meet on Monday. Our point last year had been that no deal would not be worse than the current deal – thus the pound should not be hit too badly on any negative headlines.

Overall, expect the BoE tightening story to keep GBP supported on dips. Additionally the heavy weighting towards Materials and Energy sectors in UK FTSE benchmark may provide UK equities with some insulation.

AUD: Another Tick Higher in Inflation, But RBA Tightening Still Far

The AUD/USD pair flattened up this week, following swings in sentiment while finding some support from a bigger-than-expected drop in Australia’s unemployment in December (to 4.2%).

The Reserve Bank of Australia is now presented with a question of whether to react to such improvements in the jobs market with a significant hawkish turn at the Feb. 1 meeting, with the counter-argument still related to growth concerns as Western Australia keeps delaying reopening plans due to the ongoing COVID-19 outbreak.

Next week, we are likely to see another tick-up in inflation in Q4 from the latest 3.0% read. While not very high compared to similar markets, it could still fuel some hawkish speculations on the RBA and help the Australian dollar, even though we doubt the RBA tightening is a story for the first three quarters of 2022. Some retreat in the US dollar could also help AUD/USD build some support at 0.72.

NZD: Another Big Jump in Inflation

It’s CPI week in New Zealand, and we expect the headline rate to jump again in the Q421 read, possibly touching 6%.

The market’s tightening expectations for the Reserve Bank of New Zealand are already quite aggressive (a 25 bps hike in mid-February and at least five more in 2022), but we think that a strong CPI read may fuel speculation that the Bank will go for 50 bps in February, which should be translated into a stronger New Zealand dollar.

We think the NZD/USD pair can make its way back to the 0.6800 mark next week, although that clearly relies on stabilization in the overall risk environment.

CAD: We Expect a Rate Hike By The Bank of Canada

A tight labor market, inflation close to 5%, investments and hiring intentions at record highs, and oil prices back to pre-Omicron levels: all of this is pointing to the need to start raising interest rates in Canada. The current restrictions in Ontario – which are however due to be eased at the end of next week – make it a close call, but we think the Bank of Canada will hike interest rates by 25 basis points on Wednesday.

The market is currently attaching a 70% implied probability of a hike, which leaves some room for the Canadian dollar to appreciate after the announcement, especially as that should reinforce the view that the BoC will lead the Fed tightening by one to two months and by 25-50 basis points. We expect a drop in USD/CAD to the 1.2400/1.2450 area if our expectations for a hike prove correct.

CHF: Mostly Downside Risks from Italian Politics

Keep an eye on Italian political developments in the week ahead, as the parliament meets to vote for the new President of the Republic. The most likely scenario appears to be a move by Mario Draghi from the role of Prime Minister to the (largely ceremonial) role of President.

While potentially fueling concerns about the implementation of the EU-funded reforms in the country with Draghi leaving the government, we think markets may welcome the fact that: a) Draghi will remain in the political picture for the next seven years (his government is due to end in the Spring of 2023); and b) no divisive candidate (like the other main contender, Silvio Berlusconi) is elected president.

The EUR/CHF pair seems to be pricing very little of a shake-up in the Italian bond market, which means that most of the risks are skewed to the downside for the pair. Domestically, it’s worth keeping an eye on the KOF leading indicator for January. With the Swiss National Bank looking less concerned about a stronger Swiss franc, we might see the downtrend extend to the 1.02/1.03 area should the Italian bond market come under pressure.

NOK: Waiting for Sentiment Stabilization

It’s going to be a rather quiet week data-wise in Norway, with some focus only on December retail sales and Norges Bank’s Wealth Fund key figures for 2021. The slump in global equities has been the major factor driving EUR/NOK this week, with the recent big move to 10.10 entirely due to the Norwegian krone's high sensitivity to equity dynamics.

This week, we heard from Norges Bank on monetary policy: while pausing the tightening cycle for now, policymakers signaled a move in March, thereby consolidating the credibility of the Bank’s hawkish rate projections for 2022. 

As discussed here, we think the case for four hikes this year is getting increasingly strong, and this should provide extended support to the Norwegian krone. For this week, some stabilization in sentiment is surely needed to send EUR/NOK back to or below the 10.00 level.

SEK: US Tech Woes Hitting the Krona

The Swedish krona is the currency with the highest positive correlation with the US tech stock market, and the recent woes in the segment (Nasdaq entering correction zone) have been a major contributor to the weak start of the year for the krona.

We’ll need to see signs that US tech shares are recovering some ground next week to see EUR/SEK converge to the center of its 10.20/10.40 range in which it traded in December and at the start of January. Some help may come from the Prospera Inflation Expectations survey should CPIF expectations climb significantly.

Later in the week, some focus will be on jobs and retail sales data, as well as on the Economic Tendency survey for January.