You don’t have to be a brain surgeon to figure out that markets became unhinged last week. The USD is the key macro variable - when you see it shoot up against all currencies by a large margin, you know something has changed. That something was Wednesday’s FOMC meeting.
Even though the FOMC statement was similar to that of the last meeting, the Fed’s dot plots and hawkish forecasts surprised everyone.
The Fed’s dot plots showed that the median FOMC policymaker now expects two interest rate hikes by the end of 2023, up from zero in the last meeting. Also, 7 of the 17 policymakers now expect at least one interest rate increase by the end of next year.
Meanwhile, the Fed’s forecasts showed that the median Fed member revised down their projections for the 2022 unemployment rate to 3.8%, while concurrently revising up their projections for 2021 and 2023 growth to 7.0% and 2.4% respectively, as well as 2021 and 2022 core inflation to 3.0% and 2.1% respectively.
To summarize, the Fed now believes the US economy will approach its dual mandate of inflation averaging 2% and maximum sustainable employment more quickly than previously believed. The narrative has changed, and the timeline has moved up for tapering QE and raising rates. The market had priced in a rate hike by the end of 2022, and now (post-FOMC) it is discounting to about a 60% chance of a second hike.
What happened? For months, the Fed has been preaching tolerance for their policy. They kept preaching that inflation was transitory and that employment had to recover to pre-pandemic levels before they even thought of changing tack. It was working too, as 10-year yields had fallen over the last two months from 1.7 to 1.44.
On Friday, James Bullard, President of the Federal Reserve Bank of St Louis, provided some colour in the Fed’s change of heart. To summarize, Bullard said:
- FOMC was surprised on the upside over the last few months; it’s natural we tilted a bit more hawkish.
- Inflation was more intense than expected.
- Powell officially opened taper discussion this week; more in-depth discussion to follow.
- Leaning toward idea Fed may not need to be in MBS.
Bullard’s message was clear: inflation is more than transitory, so tapering is coming sooner rather than later. That is all the currency market needed to hear to hit the bid on the USD. While a day or two of price action does not a trend make, the market is sending some peculiar signals that need to be monitored.
The US dollar index has gone up in 5 of the past 6 weeks and given the crowded bets against the USD, the move could run further. Having said that, the index had a three-standard deviation move last week alone so a short-term correction would be warranted.
We will be paying close attention to the weekly chart of both the US dollar index and the euro in the weeks ahead. On the dollar index, I will be looking to see if it can break the inverse head and shoulders formation.
Conversely, the opposite formation is seen on the euro chart.
If these two formations break, a new narrative will be in play.
Fedspeak will be front and center this week- there are 16 FOMC members speaking at events. Was Bullard the only hawk? Will they all shift to a more hawkish stance? We’ll have to wait and see.
Senior FX Dealer,
Global Treasury Solutions
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