Morning Brief – Hot Air

Hot Air

A change of tide has begun in the foreign exchange market. However, it is not one that will float all ships. Finally, an acknowledgement of rising inflation expectations in the United States and globally has coerced the Federal Reserve to begin the path towards a discussion about tapering rates it seems. Their decision published last week showed a much faster pace of expected interest rate hikes and more prolonged, sustained rates of core inflation. The move hauled the Federal Reserve’s Board in line with market expectations and set the path towards monetary normalisation in the United States and, likely, the rest of the world. In doing so, the historically low levels of implied and realised volatility were blown out of the water and somewhat directionless markets were given momentum. So far this week, the appreciation of the US Dollar has taken a breather following last week’s FOMC decision. So what are markets on the lookout for now?

Since the decision was published last week, the US Dollar has gained approximately 2% versus the Euro. The value of Gold measured against the Dollar has tumbled approximately 5% since last week’s decision. Commodity currencies including the Australian and Kiwi Dollars have also had a comparably sharp fall (approximately 2.5% a piece) and have moved almost in tandem versus the US Dollar as the greenback continues to be the driving force on major FX crosses. Emerging market currencies too have succumbed to the weight of the US Dollar for two main reasons. Firstly, those emerging market currencies that were seeing increased demand particularly in forward markets as a result of the higher rate of interest they offered are now offering a weaker reward when compared with the market’s expectations for the US Dollar. Secondly, many emerging market currencies offer hard debt issued in a foreign currency, usually USD. This debt, much of which has grown in size and yield as a result of the pandemic, becomes harder to service and afford repayments on as the cost of borrowing and indeed purchasing USD rises in markets. Accordingly, emerging market currencies including the SA Rand and Mexican Peso are down circa 3-3.5%.

Following last week’s Fed decision we have been offered several further insights into the expectations for US monetary policy. The market was shocked last week by the Fed’s overall approach to future policy but we have now also heard from individual policy markets allowing markets a better insight into individual decision makers’ thoughts. Yesterday, regional Federal Reserve presidents Robert Kaplan and James Bullard spoke offering a more detailed picture of the Fed’s thinking. Whilst highlighting a preference towards beginning the process of tapering bond purchases “sooner rather than later”, these familiar names provided a more toned-down approach and likely contributed to the cooling off of the Dollar’s advance yesterday.

Given the magnitude of monetary normalisation across the globe it is clear that rhetoric coming from the Federal Reserve and other key global central banks will be the driving force of foreign exchange markets in the weeks and months to come. Advanced vaccination programmes in the world’s major nations have curtailed (for now) the extent to which currencies are correlated with covid infection rates and lockdown policies. In line with the market’s current fixation on interest rates and monetary normalisation, this evening’s testimony by Federal Reserve Chairman Jay Powell could provide a key piece to the puzzle. Now that the market’s short USD positioning is likely corrected, fresh direction and clarity on the path of US rates will provide stimulus and direction to major currencies. Today’s testimony at 18:00 GMT is expected to see Chairman Jay Powell talk down the probability of any rate hikes next year. If successful, this could provide relief to the Dollar later today, however, the Chairman will have to treat a careful path to avoid further Dollar buying.

Discussion and Analysis by Charles Porter

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