USD, EUR and GBP

USD: Compromise comes at a price

Yesterday, it seemed to me that Jerome Powell may have been inspired by the well-known verse “a spoonful of sugar helps the medicine go down.” He and his FOMC colleagues provided markets with a few dovish hints while also delivering a potentially painful 25bp rate hike. Those hints primarily consisted of the view that “some additional policy firming may be appropriate” - not “will be appropriate” as before - and on keeping the median dot plot estimate for 2023 unchanged at 5.1%. The statement was accompanied by a well-telegraphed message of trust in the solidity of the US banking system, and Powell did offer modest pushback against rate cut expectations during the press conference. However, I doubt the dovish market reaction was a surprise or an unwanted development for the Fed. Many had argued that one objective of the Fed yesterday was to avert a major setback in financial market sentiment, and the market reaction would suggest that this was achieved. The drop in equities might be mostly a function of Secretary Janet Yellen dismissing speculation that the Treasury is planning to provide “blanket” deposit insurance to banks. However, that came at a price: a considerably less clear Fed communication.

I believe that no trade-off between price and financial stability is essentially possible only if financial conditions tighten (due to banking stress) enough to bring down inflation or if regulators and other institutions effectively manage to restore market confidence without anything more than the financial stability tools offered by the Fed. This second scenario requires indeed that, as Powell stated, the US banking system is very solid. So far, markets are not trusting the ability of the Fed to treat inflation and financial stability independently. This looks unlikely to change soon, which means that rate expectations should remain strictly tied to developments in the banking crisis. This brings me to the FX implications.

The dollar weakened on the back of the moderate dovish surprise by the Fed yesterday, and there was reluctance from the Treasury to consider an extension to the deposit insurance. At the same time, PacWest, a new regional lender, is facing increasing turmoil on deposit outflows, and First Republic’s rating was cut from BB to B by Fitch. Therefore, with a market not trusting the more ambiguous Fed communication and the US regional banking crisis far from resolved, it looks like investor bias on the Fed may stay on the dovish side. This should translate into a continued bearish bias for the dollar, primarily against European currencies should the stabilisation in European sentiment continue. Still, I see a high chance of seeing small USD upside corrections on the way, rather than a straight-line USD depreciation.

EUR: Central bank meetings in Switzerland and Norway

EUR/USD is now officially eyeing the 1.1000 level. (as I have been mentioning here: https://acy.com.au/en/market-news/market-analysis/looking-back-on-eurusd-151846/ ) I discussed think that is a key benchmark level for the pair, and I think a break higher would likely mark a rather strong conviction call from the market that the Credit Suisse shock has been successfully absorbed by European markets. That may be a bit premature, and I flagged in the USD section above how the USD bearish bias surely doesn’t prevent EUR/USD corrections on the way. In the current elevated volatility environment, those corrections can be quite pronounced, even if short-lived.

GBP: BoE to hike

Markets are now fully priced by the 25bp hike yesterday on BoE and will therefore look for some indications that the further 40bp currently embedded in the GBP OIS curve is warranted. The division within the BoE’s MPC may be nothing but exacerbated by the recent market turmoil, the risk is that markets may receive very little guidance on future policy paths. Ultimately, the pound may rapidly default to being driven by external factors: primarily the banking situation and global risk sentiment. A test of 1.25 in cable in the coming days is looking quite likely.

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