FX Daily: Hawkish Pushback

Dovish bets have been scaled back in the US, but I continue to see mostly downside risks for the dollar and expect EUR/USD to test 1.10 soon. But beware of corrections along the way.

USD: Fed’s lack of clarity counts more than the magnitude of cuts

FX markets continue to move in line with our baseline view: the lack of clear guidance from the Federal Reserve and hawkish rhetoric in Europe is favouring a weaker dollar amid a calmer risk environment. It’s important to note how the dollar has softened since the start of this week despite some substantial unwinding of dovish bets on the Fed funds futures curve. Markets moved from pricing in a 24% chance of a hike in May and 88bp of cuts by year-end on Friday to a 47% implied probability of a hike in May and 46bp of cuts by year-end as of this morning.

In a way, this is telling us how it’s the stance of the Fed and its unclear communication (especially given the contrast with the European counterparts) that leaves the dollar vulnerable in a stable risk environment and not necessarily the magnitude of expected rate cuts.

So, is it going to be a straight-line dollar depreciation from now on? I don’t think so. The room for corrections is non-negligible, and those can be triggered either by new risk-off waves outside of the US (like the one seen in Europe on Friday) or by attempts from Fed members to re-establish more hawkish rhetoric. While the first of these two triggers is harder to predict, the chances of a more hawkish tone in upcoming Fed speak might have increased after a few days of market calm and investors scaling back ultra-dovish expectations. However, the bias for the dollar remains mostly bearish in our view.

This week is seeing oil currencies coming to the fore. With crude prices having now rebounded more than 12% since the 20 March bottom and re-approaching $80/bbl, the soft-dollar and more stable risk environment is offering room for Norway's krone, the Canadian dollar, and the Mexican peso to rally. Of those three, I continue to see MXN and NOK in a more advantageous spot than CAD given ongoing domestic tightening cycles. Banxico will announce policy tomorrow and I expect a 25bp hike in line with market expectations.

EUR: 1.10 within reach

Yesterday, we heard European Central Bank policymaker Georg Muller joining the rhetoric of other hawks like Isabel Schnabel in signalling how the focus should remain on inflation and that there is still room to raise interest rates. Schnabel herself – as well as another hawk, Peter Kazimir - will deliver remarks today, while the data calendar in the Eurozone is quite light until inflation flash estimates are released on Friday.

The EUR-USD 2-year swap rate differential has shown extreme volatility lately as Fed rate expectations have swung widely. The spread ranged between -75bp and - 100bp (where it is now) in a matter of a few days. As discussed above in the USD section, the magnitude of the Fed rate cuts does not matter all that much for the dollar's direction now.

Markets are preferring to stay on the more hawkish side (Europe) and the swap rate spread has tightened enough to warrant a higher EUR/USD in a stable risk sentiment environment, without that spread having to reach the extremes of -70 or -60bp seen in the past weeks. In our dollar section, I also discussed how the chances of corrections are non-negligible and may have increased in the past few days, but there are not enough elements to conclude that the Euro should lose its upside momentum now. So, 1.10 should be within reach in the near term.

That is a key benchmark level and could see significant resistance: a break higher would likely signal a more structural shift in market strategic views for a stronger Euro. In the crosses, we saw EUR/GBP fall below 0.8800, but I don’t expect the pair’s weakness to be very sustainable as I see the market pricing for Bank of England tightening as too aggressive and policy divergence should be a primary driver for a higher EUR/GBP.

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