The Spectre Of Volcker Looms Large On Currencies
2022.09.14 08:57
Higher than expected US has seen an extra 25bp added to expectations of the Fed tightening cycle, yield curves invert further, equities fall sharply and the surge. The spectre of the early 1980s looms large. This also brings the return of a more interventionist approach to FX markets. Expect volatility to rise and the dollar to stay strong
US Dollar: Recessionary fears grow
Yesterday’s release of stubbornly high August CPI has increased fears that the Fed will need to slow demand even further to bring inflation back to its 2% target. This period in the global macro-financial cycle again recalls the early 1980s experience with Paul Volcker at the helm of the Fed. To put the inflation genie back in the bottle, Volcker took policy rates to 15% and was prepared to accept recession as collateral damage. No one in the market thinks the Fed funds policy rate is going above 10% anytime soon, but yesterday’s inflation release did see the terminal Fed policy rate re-priced to 4.30% from 4.00%.
That re-pricing of the Fed funds cycle – or the pricing of a harder stamp on the brakes – saw the US bearishly invert 10bp on the day to -34bp and the fall 4%. Inverted curves typically are late economic cycle phenomena and are normally associated with a stronger dollar and weaker activity currencies in particular. On cue, commodity currencies fell around 2% against the dollar yesterday and remain vulnerable.
Dollar strength has been broad-based and is starting to elicit a stronger response from trading partners. In early Asia, got close to 145.00 again and this time prompted a report from the news service that the Bank of Japan had been ‘checking rates’. This is a throwback to the 1990s period of serial Japanese FX intervention where ‘checking rates’ meant the BoJ FX intervention desk would be asking dealers for direct prices ahead of intervention. It does feel that intervention is close at hand – there is a small risk of it today at the New York open 13-14CET. If the BoJ is preparing to do battle with the market, we think USD/JPY implied volatility is still far too low. 3m USD/JPY implied volatility could easily be trading up at 18% versus the 12.7% levels today.
Beyond the risk of FX intervention, today’s US data calendar is light – though August might be in focus. Were there BoJ FX intervention, Japanese authorities could easily sell around $5bn. That could trigger a brief dollar correction. However, the dollar is up here for good reasons and we would expect the macro hedge fund community to be happy to buy dips on any 2-3% correction in USD/JPY. Barring intervention DXY should stay bid near 110 as the market awaits a hawkish FOMC meeting next week.
Euro: ECB story struggles to lift the euro
Yesterday’s re-pricing of the Fed cycle saw a 20bp widening in the two-year EUR:USD swap differential – leaving it wider than where it was before last week’s hawkish European Central Bank meeting and pressuring . In short, the ECB will struggle to out-hawk the Fed. That is not a surprise given the US economy went into this inflation crisis with an economy operating above capacity – unlike the negative output gap in the eurozone.
The highlight of today’s session will be European Commission President, Ursula von der Leyen, unveiling what measures Europe stands to take to address the energy crisis. The prospect of liquidity support for utility companies does seem to have calmed energy markets – but that leaves German power prices just double, instead of triple what they were in the early summer. We doubt these support measures can make a meaningful difference for EUR/USD pricing, leaving it to trade offered in a 0.9950-1.0050 range.
Pound Steling: 50bp still on the BoE table for next week
The market looks caught between pricing a 50bp and 75bp Bank of England (BoE) hike at next Thursday’s (Sept. 22) policy meeting. We are still looking for a 50bp hike – a move supported by today’s marginally softer than expected UK August CPI release.
The overall environment, however, remains negative. Running a large current account deficit and having a large financial sector representation in the UK economy, slowing growth and weaker equity markets should leave sterling as an underperformer. And the jury is still out on whether Gilt investors will balk at upcoming Gilt supply.
This all leaves sterling at the mercy of the strong dollar, where we expect a retest of the 1.1406 lows. And further equity weakness would send back to the top of an 0.8650-0.8720 range.
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