Foreign exchange markets were mixed in late December and through the early stages of 2022 as FX traders tried to figure out just how hawkish the Fed is. But as you can see by GBP, any major G10 currencies appreciate when the domestic central bank unexpectedly raises rates (holding all else equal). Still, so far, the FOMC hasn’t surprised bond markets with their so-called hawkish pivot.

Typically, the US dollar strengthens in the six-month run-up to the first Fed rate hike in a tightening cycle but weakens more often than not in the first year following the first hike. However, every rate hike cycle is different, so it’s not going to be automatically “buy the rumor sell the fact.” But two things we need to keep an eye on are the 1) Fed’s impact on risk appetite and its feedback on policy expectations and 2) just how predictable the Fed rate hikes prove to be.

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As for US bonds, “get short in January” was the consensus after the Omicron-driven rally in December. And 10yr yields increased, reflecting the risks that Omicron could disrupt supplies again and lead to a rebound in inflation. Still, the move has already happened for the most part, so picking a direction at this level is much more complex, and it’s not surprising to now see the US dollar stall awaiting the next big moves on Bonds. Indeed, it will take a while to resolve the tug of war between downside risks to Q1 growth, the medium-term tailwind of Omicron being a less-deadly COVID variant, or uncertainty over how quickly inflation falls 

Nonetheless, if hospitalizations remain low relative to the number of new covid cases, investors can look beyond a near-term hit to growth, notwithstanding global fiscal headwinds. Bear-steepening pressure that we are seeing currently, driven by inflation breakevens, continues to hold the US dollar back and provides a fillip for gold. For example, while the US 10y yield is unchanged, the 2s10s curve bear flattens 2.5bp ahead of the FOMC minutes, and the overnight US Dollar selloff accelerated.

However, the December FOMC minutes showed members discussed earlier rate hikes before meeting the max employment target; discussion on the balance sheet runoff is more interesting. Some participants want to start balance sheet runoff soon after the rate hike to prevent curve flattening. Meanwhile, balance sheet runoff this time should be quicker than the previous one. The primary balance sheet runoff started in Q4 2017 and stopped in mid-2019. More rapid balance sheet runoff should support long-term yield. US 10y yield is trying to break to 1.70% level and somewhat USD supportive, and US equities are falling further.

A quicker balance sheet runoff would be worse for long-end bonds, whereas a very slow unwind would keep long-end yields contained but require more interest rate hikes. In turn, surprise hikes would have a more significant impact on the USD. Yellen said quantitative tightening would be like “watching paint dry” last cycle. Chair Powell indicated that things could be very different now and that a decision is likely this quarter. The balance sheet, not lift-off, is the big question waiting for an answer in Q1.

As ever, ADP tends to be a hit or miss. In a 1-year look-back, the correlation between ADP and NFP having the same way surprises stand at only 16%. That suggests fragile predictive power.

I think FX traders are comfortable trading US dollar-neutral strategies to start the year while taking the path of least resistance in buying currencies where there is a good chance the central bank will raise interest rates soon. And that said, I am not getting the solid bullish USD signal early in 2022 as real rates are getting pressured by inflationary higher oil prices.

So US dollar bulls may need to count on a sturdy NFP on Friday to keep the US dollar trading on a firmer footing. But certainly, the more hawkish than expected FOMC minutes could trigger an exodus of freshly minted short US dollar positions. But is it enough to drive the EURUSD below 1.1270? Likely not as traders may now start reducing instead of adding positions ahead of Friday’s NFP, but central bank surprises can also lead to market surprises.