Fed Signals Higher Rate Peak

Fed signals higher rate peak & opens door to return to larger hikes

I have noticed that the US dollar has been trading at much stronger levels during the Asian trading session, and it seems to have regained upward momentum from Wednesday. As I look at the dollar index, it has risen to a fresh year-to-date high overnight and is now getting closer to the 200-day moving average at 106.6. I think this is due to the hawkish policy signals delivered by Fed Chair Powell at Wednesday semi-annual testimony to Congress. His comments have caused the US dollar to strengthen sharply.

Over the last couple of days, I have seen that the hardest hit G10 currencies have been the Scandi currencies, particularly the Swedish krona (-2.7% vs. USD) and Norwegian krone (-2.6%). However, all G10 currencies have fallen by over 1.0% against the US dollar. It's interesting to note that the US dollar has regained upward momentum after Fed Chair Powell gave the green light for the US rate market to continue pricing in more aggressive rate hike expectations for this year.

After listening to Fed Chair Powell's semi-annual testimony on monetary policy, I can tell that the Fed has been rattled by the stronger activity and inflation data in recent months, along with the upward revisions to the previous quarter. This suggests that inflationary pressures are running higher than expected at the time of last month’s FOMC meeting.

HAWKISH FED HELPS USD TO REGAIN UPWARD MOMENTUM

I was following Fed Chair Powell's recent statements, and I noticed that he delivered two clear hawkish policy signals regarding further monetary tightening. Firstly, he mentioned that the latest economic data "suggests that the ultimate level of interest rates is likely to be higher than previously anticipated." This statement clearly indicates that the Fed no longer thinks that just a couple of more 25bps rate hikes will be sufficient to tackle the inflation problem.

Before Wednesday semi-annual testimony, the US rate market had already fully priced in just over 75bps of further rate hikes. Since then, it has moved even further to fully price in 100bps of rate hikes, which would raise the policy rate to just over 5.50%. This has helped to lift US rates to fresh cyclical highs at the short-end of the US curve, although yields at the longer end of the curve remained relatively stable. As a result, the US rate curve has become even more deeply negative, with the spread between 2-year and 10-year US treasury bonds moving below -1.00%.

From what I can tell, this could further highlight the building risk that the Fed will overtighten and trigger a recession in the coming years. It's important to keep an eye on these developments and see how the Fed will continue to address inflationary pressures moving forward.

I was interested to hear that Fed Chair Powell delivered a second hawkish policy signal during Wednesday testimony. He re-opened the door to a quick return to larger 50bps rate hikes, stating that "if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes." I think this was the biggest hawkish policy surprise yesterday, especially given that the Fed had slowed the pace of hikes at the last two policy meetings in December and February. This quick shift in policy thinking has created some confusion over the Fed's policy reaction function.

As Fed Chair Powell mentioned in Wednesday semi-annual testimony, "in light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, the Committee slowed the pace of interest rate increases over its past two meetings." This is an important factor that argues against returning so soon to larger 50bps hikes. Whether the Fed delivers a larger 50bps hike at the next policy meeting on 22nd March will depend heavily on the incoming economic data, including the release of the latest NFP report on Saturday. This report will take on even more importance now for driving FX market performance.

At this point, I still believe that a 25bps hike in March is more likely overall, but another larger 50bps hike is now clearly a high probability event. We will have to continue monitoring the Fed's policy decisions and the impact they have on the market moving forward.

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