Dollar strong ahead of Fed meeting

Important calendar events

• EUR: German PPI, Current Account, ECB President Lagarde speech
• USD: Building Permits, Housing Starts

USD

The dollar gained strength on Monday and the dollar index climbed above the 110 level. US Treasury yields rose, with the US 10-year bond yield touching 3.5%. 

A surprisingly high US inflation report last week propelled the dollar upwards. CPI increased by 0.1% in August and Annual CPI through August increased by 8.3%. US inflation data are propping up the dollar, as the Fed is likely to maintain a hawkish stance this month to combat persistently high inflation rates.

Fed rhetoric propelled the dollar to 20-year highs in the past few weeks amidst mounting expectations of a steep Fed rate hike. The US Federal Reserve is expected to continue raising its benchmark interest to combat persistently high inflation rates. Inflation in the US is not cooling at the expected rate, putting pressure on the Fed to maintain its hawkish stance. Recent US economic and employment data were robust, indicating that the US economy can withstand aggressive tightening. 

This week, all eyes are going to be on the much-anticipated Fed monetary policy meeting on the 21st as Fed is set for another steep rate hike. Markets are currently wavering between a 50-bp and a 75-bp Fed rate hike on Wednesday, with odds favoring a 75-bp rate hike, while recently traders have started betting on a 100-bp rate hike. 

The Fed policy meeting is expected to generate high volatility for the dollar. The ensuing FOMC statement might also affect the dollar strongly, as well as Federal Reserve Jerome Powell’s press conference following the Fed meeting. As this week’s rate hike has been largely priced in, market participants will pay close attention to Fed statements to gauge the Fed’s future direction.

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EUR

The Euro struggled to maintain parity with the dollar on Monday for the fifth day in a row. The EUR/USD pair was testing the support at the strong psychological parity level of 1.000 throughout the day. If the EUR/USD declines further, it may find support at the 0.845 level representing the 2002 low. If the currency pair goes up, it may encounter resistance at 1.019 and further up at 1.036. 

In its latest monetary policy meeting, the ECB raised its benchmark interest rate by 75 basis points, hiking its deposit rate to 0.75% from zero. Hawkish ECB rhetoric has propped up the Euro, with ECB officials pointing at further rate hikes this year.

The US Fed, however, will likely match the ECB’s rate hike this week, as inflationary pressures in the US remain high. Market estimates point to a 75-bp Fed rate hike on Wednesday, with analysts not excluding the possibility of a 100-basis point rate hike. A more hawkish than anticipated outcome to Wednesday’s meeting will likely push the Euro over the edge, breaking its delicate balancing act on parity.

Europe is facing an energy crisis driven by the EU’s dependency on Russian energy. High energy costs in the Eurozone are driving the Euro down, while inflationary pressures mount. Eurozone inflation hit a record high of 9.1% in August on an annual basis, as price pressures increased despite the fall in global fuel prices. Inflation in the EU is expected to rise even further in the following months, possibly reaching double digits, driven by the high cost of energy in the Eurozone. Increased price pressures are forcing the ECB to take swift action to tackle inflation. 

Only minor economic indicators are scheduled to be released on Tuesday for the Eurozone. ECB President Christine Lagarde is due to deliver a speech on Tuesday, which may cause some volatility for the currency. This week, the Euro is likely to be affected by the outcome of the Fed monetary policy meeting on the 21st.

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GBP

Monday was a Bank Holiday in the UK in observance of the funeral of Queen Elizabeth. The Sterling remained steady on Monday, after touching a 37-year low last week. The GBP/USD rate tested the 1.140 level support, representing the 2020 low. If the GBP/USD rate goes up, it may encounter resistance near the 1.173 level and higher up near 1.190. If the GBP/USD declines below the 1.140 support, it may plummet to a multi-decade low.

These past few weeks have marked historic changes for Britain, as a new monarch and Prime Minister have been established. A climate of political uncertainty has been putting pressure on the GBP over the past few months, especially after former PM Boris Johnson’s resignation in July. Liz Truss became UK’s next Prime Minister, bringing a measure of stability, which propped up the Sterling. Truss has announced an ambitious plan to prop up energy in the UK and reduce the average cost of energy for households, by funneling billions to the sector.

UK economic outlook remains poor, with high inflation and rising recession concerns, although annual inflation in August dropped to 9.9% from 10.1% in July.  The BOE has warned that recession is expected to hit the UK in the fourth quarter of this year, and is forecasted to last for five quarters, until the end of 2024 with GDP falling to 2.1%. 

Britain’s grim economic outlook is preventing a more hawkish fiscal policy and is hampering the BOE’s attempts to bring inflation down. In its latest monetary policy meeting, the Bank of England raised its interest rate by 50 bps, bringing the total interest rate up to 1.75%. The BOE has adopted a moderate stance, trying to strike a balance between battling inflation and supporting the sluggish economy.

The much-anticipated BOE monetary policy meeting has been scheduled for the 22nd. Markets are pricing in a rate hike of at least 50 bp at Thursday’s meeting, with a high probability for a 75 bp hike. A moderate BOE rate hike of 50 basis points will likely weaken the Sterling even further, especially if the Fed hikes interest rates by 75 bp or more a day before. 

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JPY

Monday was a Bank Holiday in Japan in observance of Respect-for-the-Aged Day. The Yen remained mostly steady against the dollar, with the USD/JPY rate hovering around the 143 level. If the USD/JPY pair falls, support might be found near 138.0 and further down at 134.2. If the pair climbs, it may find further resistance at the 1998 high of 147.7. 

Last week, reports that the Bank of Japan is conducting a rate check in preparation for currency intervention, boosted the Yen. The Yen’s extreme weakness seems to have finally caught the attention of Japanese officials. Increasing comments by Japanese officials expressing concern about the Yen’s weakness may hint at a hawkish shift in the BOJ’s monetary policy.

The BOJ maintains its ultra-easy monetary policy, keeping its main refinancing rate at -0.10%. Japan continues to pour money into the economy, while other countries are adopting a tighter fiscal policy. The difference in interest rates with other major Central Banks puts the Yen at a disadvantage, driving its price down. 

The increased divergence between the US and Japanese monetary policies has widened the gap between their respective bonds, putting pressure on the Yen. The BOJ keeps bond yields low, weakening the Yen. 

This week, the Fed’s monetary policy meeting on the 21st and the BOJ policy meeting on the 22nd is expected to affect the Yen considerably. If the Fed hikes interest rates by 75 bp or more, it will likely add more pressure on competing assets, such as the Yen. 

The BOJ is expected to keep its benchmark interest rate unchanged at Thursday’s meeting, regardless of recent statements by BOJ officials about the currency’s weakness. Currency intervention is likely still far ahead and a BOJ shift towards a more hawkish policy is expected to be gradual. However, if the BOJ statement and Press Conference following the meeting have a more hawkish tone, this may signal the beginning of a change in BOJ policy.

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Written by:
Myrsini Giannouli

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