USD: Cautious Fed policy update puts a dampener on upside

The US dollar has continued to trade at modestly weaker levels overnight after yesterday’s FOMC meeting. The US dollar has been undermined by the scaling back of Fed rate hike expectations with the 2-year US Treasury yield remaining around 9bps lower than prior to yesterday’s FOMC policy update. The Fed decided to leave rates on hold as expected overnight although there were two hawkish dissenters: Fed Governor Lisa Cook and Cleveland Fed President Beth Hammack who both favoured raising rates by 0.25 point. However, the overall tone of the updated policy statement and comments from Fed Chair Kevin Warsh in the press conference suggested more caution over delivering further rate hikes. The statement noted that “the accumulation of more information will help the Committee determine the policy stance appropriate to ensure a timely return of inflation” to their inflation target. At the same time, it described economic activity as expanding at a “strong pace” supported by “strong” productivity growth and “robust” capital investment. In the accompanying press conference, Fed Cahir Kevin Warsh added that the Fed would benefit from the “information rich interval” between now and the December FOMC meeting. It indicates that the Fed is still planning to hike rates again in December but the decision remains data dependent.

On the more cautious side, he acknowledged that “we’ve started to see some change in financial conditions” which have tightened although he was “unable to call them tight”. When referring to the tightening the Fed has already put in place, he said I have been encouraged by progress we’ve made in short period describing the December rate hike as removing a “dose of accommodation”. He added that the “overwhelming consensus [on the FOMC] was that the medicine is starting to work. He also emphasized that the recent rate hie is already having an impact on AI highlighting that the sector is not insensitive to higher rates. He stated that interest rates have an impact on the technology complex with market participants discriminating more recently on investments as it has become harder for highly leveraged neocloud companies to secure finance. When asked about the strong economy, he stated that “most at the Fed don’t think the economy is running too hot”. He remains optimistic on the outlook for stronger productivity which would allow the US economy to grow more strongly without creating upside inflation risks. He believes most of the recent increase in productivity came before the impact of AI which is likely to strengthen productivity growth further.

Overall, the comments push back against expectations for more aggressive Fed rate hikes by acknowledging the recent tightening in financial conditions and stronger productivity growth. It supports our forecast that the Fed may deliver only one further hike. While the scaling back of Fed rate hike expectations will put a dampener on the US dollar’s upward momentum, it is still deriving support from negative developments overseas including higher energy prices and heightened fiscal and political risks in the euro area.  

YIELD SPREADS ACTING AS DAMPENER ON FURTHER USD UPSIDE

Source: MUFG Research, Macrobond, Bloomberg

EUR: Tighter financial conditions to trigger ECB caution over further hikes

The market’s focus will now shift to the ECB’s policy update later today which will attract even more attention than normal given the sharp sell-off in French government bonds which is making the ECB’s job in setting monetary policy even more challenging. We had previously thought that another back-to-back hike was possible encouraged by another upside inflation surprise in September coming in at 3.8%. The price of natural gas in Europe has hit fresh year-to-date highs this month rising further by around 40% and adding to upside inflation risks in the euro area. However, the unwanted tightening in financial conditions triggered by the higher government bond yields particularly in France are expected to make the ECB relatively more cautious over the need for further rate hikes and support a decision to leave rates on hold today. The 2-year German government bond yield has already fallen by around 25bps from last month’s highs. The scaling back of ECB rate hike expectations ha been one reason why the euro has underperformed in recently. Market participants will be listening closely to updated guidance from the ECB today to better assess how much tighter financial conditions are likely to impact the policy outlook. We still expect another hike by the end of this year in December.  

President Lagarde is also likely to be asked about other ways the ECB could respond to the loss of confidence in French government debt. It would become bigger problem for the ECB if there increasing spillovers to other euro area members that could threaten the smooth transmission of monetary policy. Other potential policy options include slowing down or pausing QT to help ease upward pressure eon government bond yields in the euro area, and/or potentially using the Transmission Protection Instrument (TPI) as a last resort to purchase government bond yields if the smooth transmission of monetary policy is disrupted. At the current juncture, we believe it is likely premature for the ECB to send a strong signal that they are preparing to use these policy options. Overall, we believe that risks remain titled to the downside for the euro. Please see our latest FX Weekly report for more details (click here).