Hawkish Fed Minutes Raise the Bar for Data Disappointment

Yesterday’s release of the June FOMC minutes gave very few reasons to doubt the Fed’s determination to keep raising rates. In a way, the bar for data disappointment and consequent dovish repricing may now be higher.

USD: Growth and jobs under the microscope

The minutes of the June FOMC meeting presented a clear and unequivocally hawkish stance. The summary of opinions highlighted some divergence within the committee, with a few members advocating for a rate hike in June. However, they agreed to a pause for now and instead signalled an intention for further tightening through the new dot plot projections. Most participants believed that more tightening would likely occur later this year.

The minutes also acknowledged the ongoing strong growth of the GDP and persistently high inflation, particularly with regards to core inflation, which has not shown any signs of easing this year. The Federal Reserve noted that credit availability remained intact for high-rated borrowers but mentioned that lending conditions had tightened further for those dependent on banks. Nevertheless, the risk of a credit crunch was considered low.

Overall, the minutes provided no reason to doubt that the Federal Reserve would proceed with a rate hike in July, as it is already heavily anticipated (85% priced in), unless economic and inflation data significantly shifted in the opposite direction. However, the hawkish tone of the minutes may have raised the bar for data to disappoint and cast doubt on further tightening.

The hawkish FOMC minutes have provided the dollar with some strength, clearly indicating a path towards more tightening. Consequently, it would likely require a significant downside surprise for the markets to reconsider their expectations. Bearing this in mind, the dollar's response to today's data may not have a long-lasting impact, especially if tonight’s payrolls report continues to support the idea of a tight job market and keeps the possibility of a post-July rate hike on the table.

EUR: Downside risks into the weekend

In May, medium-term consumer inflation expectations in the Eurozone continued to decline, as the 12-month expectation gauge dropped from 4.1% to 3.9%. However, the long-term (three-year) inflation expectations, which are of greater interest to the European Central Bank (ECB), remained unchanged at 2.5%. This level is significantly higher than the ECB's target of 2%. Considering the latest flash core Consumer Price Index (CPI) estimates for June, the ECB hawks have ample justification to continue their tightening measures.

Today, the economic calendar in the Eurozone is relatively light, and the EUR/USD exchange rate will be influenced by the market's reaction to US data. I anticipate that the currency pair may face downward risks in the latter part of the year, as the minutes from the Federal Open Market Committee (FOMC) meeting have set a high threshold for data to convince the markets to discount the possibility of further rate hikes by the Federal Reserve. Currently, there is still a discrepancy of around 20 basis points between the Fed's communication (as reflected in the dot plots) and market pricing. On the other hand, the ECB's communication aligns closely with the EUR Overnight Index Swap (OIS) curve, which currently implies two rate hikes by the end of the year. If US data releases turn out to be strong, EUR/USD could potentially slip below 1.0800 before the week concludes.

GBP: Watch for data outliers

Market sensitivity remains high regarding any new developments concerning prices, and the still relatively aggressive expectations for tightening by the Bank of England (projecting a 140 basis point increase by January 2024) suggest a potential risk of reassessment. Such reassessment could lead to downside risks for the British Pound, impacting the GBP/USD exchange rate. EUR/GBP has shown weakening in the past two sessions, but it may find some support at current levels and potentially converge back towards 0.8600 as the previously overbought pound faces a potential repricing threat from the Bank of England.

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