FX Daily: Policy Divergence Leaves Dollar Vulnerable

Markets have reassessed the risks to European lenders and looked considerably less concerned as markets re-opened on Monday. If this calm in Europe continues, monetary policy divergence is what may be left driving most FX dynamics, and the stark divergence between Fed and European central banks’ narratives points to dollar downside risks.

USD: Fed rate expectations keep bouncing around.

Yesterday, I observed that the risk sentiment in the market had recovered. The health of European lenders was causing concern and resulted in a sell-off on Friday. However, as the day progressed, investors appeared to be calmer about the situation. It was noted that the narrative of banking turmoil shifting back from the US to Europe was the key driver of a dollar rebound towards the end of the previous week. At the start of this week, I am not surprised to see investors tentatively optimistic. Coincidentally, the USD has weakened.

I believe that the reason for this is because when we strip out the risks of financial contagion in Europe, monetary policy appears to be heading in two different directions in Europe and the US. From the comments made by the ECB and Bank of England, I can see that European central bankers are more comfortable than their US counterparts when it comes to pushing ahead with a hawkish narrative. For example, Neel Kashkari, one of the FOMC's biggest hawks, warned about the economic impact of a credit crunch and implicitly suggested less need for tightening.

Since the Fed is not offering a hawkish narrative to lean on, the market pricing of future rate moves remains strictly tied to news on financial stability. Consequently, Fed rate expectations have become an accurate measure of market sentiment about the banking turmoil. Since the end of last week, I have noticed that markets have priced out a rate cut in July and pushed it to September. Now, they expect 60bp of easing by year-end as opposed to almost 90bp. I believe that this is probably due to the beneficial effect of First Citizens acquiring Silicon Valley Bank over the weekend.

In terms of FX, I think that as long as fears of banking contagion remain relatively quiet in Europe, the balance of risks for the dollar should remain tilted to the downside. In my opinion, we could see markets once again favour JPY for tactical defensive positions.

EUR: Schnabel keeps hawkish tone going.

Isabel Schnabel reinforced her profile as one of the most hawkish members of the ECB governing council yesterday, as she said she wanted the ECB March statement to include a reference that more hiking was possible. Her comments likely helped push market rate expectations in the eurozone a little further: 46bp of tightening is now priced in by September. I think EUR/USD can retain some bullish momentum on the back of the ECB's hawkish narrative and calmer investor nerves on the European banking situation. MY view remains that 1.10 can be reached quite soon, although bumps along the way are highly likely. (as mention on this blog post: https://acy.com.au/en/market-news/market-analysis/risk-re-assessment-l-s-110000/)

GBP: Bailey helping the pound.

Bank of England Governor Andrew Bailey sounded relatively hawkish in his remarks yesterday. While saying that rates should not be taken to the 2008 peak, he stressed how the UK banking system is in a sound position and that inflation remains the key focus, and that further rate hikes are possible if inflationary pressures persist.

With BoE rate expectations now supported, I think GBP/USD can head towards the key 1.2426 (December high) and 1.2500 resistances on the back of USD weakness and policy divergence relatively soon.

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