One Last Quiet Day

This will be the last day of relative calm in markets, ahead of two days packed with big central bank action. Investors are holding on to the dollar into the Fed, which signals expectations for a hawkish hold, while the euro is finding some modest support from speculation of ECB addressing excess liquidity.

USD: Positioning consolidates in favour of dollar ahead of key events.

Investors are preparing for a series of upcoming market risk events this week, resulting in a relatively calm day today. The action is set to kick off with the Federal Reserve meeting tomorrow and UK Consumer Price Index (CPI) today, followed by four central bank meetings in Europe (in the following order: Sweden, Norway, Switzerland, UK) on Thursday/Friday.

The value of the US dollar experienced a slight dip in yesterday's afternoon session but has largely held its ground near the highs observed in March, with the Dollar Index (DXY) remaining above 105.00. The recent surge in oil prices, with Brent crude reaching $95 per barrel, has contributed to the dollar's strength. This is partly due to the United States being a net oil exporter and because it presents a counterargument against becoming excessively optimistic about US inflation. It seems that market participants are content with retaining their dollar positions established recently in anticipation of tomorrow's Federal Open Market Committee (FOMC) meeting, indicating a prevailing expectation of a somewhat hawkish stance.

Data from the Commodity Futures Trading Commission (CFTC) reveals that net dollar positioning has been increasing for eight consecutive weeks and has now shifted into a net-long position. Speculators are still holding a net-long position in EUR/USD, accounting for 15% of open interest as of last week. However, this is the lowest level since October 2022, which might limit the dollar's upside potential. Nevertheless, as discussed in my Federal Reserve preview, the dot plot projections should provide sufficient support to the dollar.

Consequently, DXY is likely to continue trading near the 105.00 mark leading up to the Federal Reserve meeting.

EUR: ECB addressing excess liquidity?

The beginning of the week has witnessed a modest rebound in EUR/USD, as it strives to recover above the 1.0700 mark following the sell-off triggered by the European Central Bank (ECB). EUR bears had been eyeing the March lows at 1.0520, and there's a possibility that we may test the 1.050/1.0550 range. This potential decline could be driven by a hawkish stance from the Federal Reserve, which might negatively affect the global risk environment. Moreover, the resilience in US economic data supports the notion of interest rates remaining higher for a prolonged period.

On the ECB front, recent reports indicate that the ECB is contemplating how to address the issue of excess liquidity in banks and is considering the possibility of raising reserve requirements. Such a move would effectively tighten monetary conditions further. This news led to a slight strengthening of the euro, but it's unlikely to reverse the trend for EUR/USD, given the broader interest rate differential between the Federal Reserve and the ECB.

Market sentiment remains sceptical about the ECB's willingness to implement additional rate hikes, especially considering the dovish tone in the recent ECB statement. The implied probability of another 25 basis point rate hike is currently below 30%. Efforts by some ECB members to convey a more hawkish message have not gained traction. At this stage, market expectations are heavily reliant on economic data, both for the Fed and the ECB, and attempts to influence rate expectations through out-of-meeting communications have had limited success.

Notably, Bank of France Governor Francois Villeroy hinted that a 4% interest rate might be the upper limit.

GBP: Underperforming into the BoE

Over the past month, the British pound has been the poorest-performing currency among the G10 currencies, and the dovish remarks from members of the Bank of England (BoE) are largely responsible for this trend. It's not surprising to observe investors adopting a generally defensive stance in the foreign exchange (FX) market as they anticipate key events in the coming days: the release of the Consumer Price Index (CPI) figures today and the BoE's announcement on Thursday. While economic data hasn't unequivocally signalled a dovish stance, the BoE's communication, when compared to prior expectations, has leaned in a more dovish direction. Consequently, even if there are signs of persistent price pressures in todays’ CPI report, it doesn't necessarily guarantee a rate hike by the BoE on Thursday.

My baseline scenario still leans toward a rate hike, although the pound's potential for appreciation hinges on the BoE's ability to convince the markets that they are prepared to take further action—a situation reminiscent of the recent European Central Bank (ECB) meeting. It's worth noting that the Sterling Overnight Index Average (Sonia) curve already incorporates an expectation of 38 basis points of tightening in total, even if the implied probability of a rate hike on Thursday stands at only 80%. This suggests that investors are pricing in a certain level of tightening, but the extent of the pound's response will be contingent on the BoE's ability to instil confidence that they have more tools at their disposal.

CAD: Inflation data important after strong jobs numbers

The surprising growth figure for the second quarter appeared to halt the Bank of Canada's plans for a mid-2023 tightening cycle. While the BoC did leave room for additional rate hikes if necessary, during its September 6th meeting, the worsening economic outlook and less concerning inflation trends have all pointed toward a prolonged pause in rate hikes.

However, the August employment data has provided a bright spot. There was a substantial increase in employment, with a 40,000-job surge, double the consensus forecast. The unemployment rate remained unchanged after three consecutive months of gradual increases, and there was a notable uptick in full-time hiring and faster wage growth. Additionally, with the rise in gasoline prices, headline inflation is expected to have accelerated from 3.3% to 3.8% in August. Both the markets and the BoC will closely scrutinize trim and median inflation measures, which are anticipated to stabilize around 3.7%.

The pair is now realigning with short-term fundamentals and a potential post-CPI rally could drive it further downward toward the 1.3400 level.

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