FX Daily: Ending the Fed’s QE may weigh on the dollar

USD: Downside risks ahead of FOMC decision

Geopolitical risks have remained firmly at the centre of investors’ focus, with markets having few indications that tensions in Ukraine are de-escalating. Equities remain in a quite fragile state (even though Western stock futures point at a recovery today), having also to deal with the now imminent prospect of Fed tightening, a prominent theme today as the FOMC announces monetary policy.

As discussed in our January Fed preview, we expect the early termination of QE asset purchases to be announced today. From a market perspective, this move may fuel speculation that the Fed may want to let the balance sheet reduction do the heavy lifting in the policy normalisation process, which could ultimately cause a dovish re-pricing of tightening expectations.

As the Fed-induced dollar strength relies on the market’s conviction around four hikes in 2022, we think that the balance of risks is skewed to the downside for the dollar today. That said, the predominance of geopolitical risk in the current market narrative and its impact on equity markets means that any post-Fed dollar weakness should not be particularly pronounced – appetite for the safe-haven dollar should remain high. Accordingly, while a cap to hawkish expectations could in theory benefit high-beta and EM currencies, a stabilisation in global risk appetite is a necessary condition for a recovery in the pro-cyclical segment.

DXY may stabilise around the 96.00 level into the end of the week.

EUR: Exposure to Ukraine still a drag

EUR/USD has been hovering around the 1.1300 level this week, with a supported dollar and adverse exposure to the Ukrainian crisis keeping moderately bearish momentum alive. The implications of forthcoming sanctions to Russia for the EU-Russia relationships (in particular related to the gas supply) are important factors for the EUR’s short-term outlook.

Until these implications become clearer, we’ll run on the assumption that the EUR will keep feeling the drag of Ukraine tensions, and a weaker dollar today after the Fed announcement may not be enough to significantly lift EUR/USD.

Some focus will also remain on Italian politics, after the first round of parliamentary votes to elect the new President of the Republic yielded no results. While current PM Mario Draghi remains the front runner for the role, parties are likely yet to reach an agreement on his replacement and the policy path from now until the spring of 2023, when new elections will be held. The longer the voting process takes, the higher the chances of a negative spillover into the local bond market – and on EUR/CHF.

GBP: Even more troubles for PM Johnson

Prime Minister Boris Johnson’s position appears to be even more compromised after allegations about another party in the lockdown period emerged and an official investigation was announced by the British police on events held in the PM’s office during the pandemic.

While most Tory MPs have pledged to wait for the result of the investigations before moving to vote out Johnson, ithere t now appears more consensus that the PM’s tenure is close to its end. Chancellor Rishi Sunak is currently seen as the most likely candidate to take over the role as PM: given no obvious implications for the UK economy or the Brexit stance for the moment, any change at the helm of the government should have a limited impact on the pound.

Cable may consolidate above the 1.3500 level on post-Fed USD weakness today.

CAD: Bank of Canada set to hike today

We expect the Bank of Canada to hike the policy rate by 25 bps today. As discussed in our BoC meeting preview, we think that the tightness in the jobs market and high inflation warrant a start of the tightening cycle already at this meeting.

A hike is around 70% priced in by the futures market, which implies some upside potential for the loonie if our call proves correct. The combination of a CAD-positive BoC meeting and a USD-negative Fed meeting ccould send USD/CAD to re-test the 1.2500 support as early as today. Any further escalations of geopolitical tensions and/or weakness in equities will clearly work against any CAD appreciation, although geographical distance and supported oil prices are reducing the loonie’s vulnerability compared to its European peers.
Source: ING