Hawkish Hold From Fed to Support USD

Fed set to upgrade GDP & lower core inflation forecasts for this year.

The US dollar continues to be one of the strongest currencies of the G10 after the FOMC meeting this morning at 4am, following the dollar index's recent peak at 105.51. As I already have mention multiple times the Federal Reserve did not alter its policy rate today, the US rate market has tempered its expectations for rate cuts in 2024, a move that has boosted short-term US rates. Just yesterday, the 2-year US Treasury yield reached an intraday high of 5.11%, a level slightly below July's peak at 5.12%. The market's priced-in expectations for Fed rate cuts by the end of the next year have diminished to approximately -70 basis points.

There were no significant US economic releases yesterday. However, the release of Canada's robust CPI report for August appeared to have an unusual ripple effect on the US Treasury market. This report triggered a more pronounced hawkish repricing in the Canadian rate market, providing further evidence that core inflation has increased in recent months. Over the last three months, the annualized core inflation measures have risen by 4.5% in August. This development adds to the challenges faced by the Bank of Canada (BoC), which had expressed concerns about core inflation declining too slowly, remaining above 3.5%. As a result of this report, the Canadian rate market has adjusted its pricing to reflect a higher probability of a final BoC rate hike either at the end of this year or in early 2024, with 29 basis points of hikes now priced in by March next year. This hawkish stance in the Canadian rate market supports my short GBP/CAD trade idea.

The Canadian CPI report is unlikely to have a direct impact on the Federal Reserve's policy outlook. Instead, US rate expectations are expected to be influenced more by the upcoming FOMC meeting. US rate strategists anticipates a hawkish stance from the Fed even more from now on, one that maintains the possibility of another rate hike later this year while reducing the number of planned cuts in 2024. The median terminal rate for 2023 is expected to remain at 5.625%, with a potential upward shift to 4.875% for the 2024 median terminal rate if there are indications of rising rates. Additionally, the Fed will unveil projections for 2026 for the first time, with the 2026 median projection for the Fed funds rate likely to resemble the longer-run dot at around 2.9%. Market participants will also closely monitor whether the longer-run median projection for the Fed funds rate is adjusted from its pre-pandemic level of around 2.5%, as this is seen as a proxy for the Fed's estimate of the longer-run neutral policy rate. Speculation among market participants has been brewing regarding a higher neutral policy rate, considering the US economy's resilience to higher rates this year. These developments are poised to support a stronger US dollar, with the main risk being if the Fed abandons plans for a final hike and Chair Powell signals a more definitive end to the hiking cycle.

GBP: Weaker UK CPI report reinforces case for less hawkish BoE policy update.

At the commencement of the European trading session, the British pound has demonstrated persistent weakness, primarily due to the disappointing UK Consumer Price Index (CPI) report for August. This decline in the pound's value has pushed the EUR/GBP currency pair towards the upper boundary of the 0.8500 to 0.8700 trading range that has been in effect since May, while the GBP/USD exchange rate has slipped below 1.2350.

The primary catalyst for the pound's renewed downward momentum yesterday afternoon was the release of the UK CPI report for August, which unveiled a more substantial decline in the core inflation rate than anticipated, dropping by 0.7 percentage points to 6.2%. This decrease took it further away from the peak observed in May at 7.1%. Although the core inflation rate remains elevated, it offers some relief to the Bank of England (BoE) ahead of today's Monetary Policy Committee (MPC) meeting.

A closer examination of the CPI report reveals that the annual rate of inflation for goods saw a slight increase of 0.2 percentage points, reaching 6.3%, while services inflation slowed by 0.6 percentage points, settling at 6.8%. Beyond the core indicators, there was also positive news as food prices continued to decelerate, registering an annual rate of 13.6% in August, which is notably lower than the peak observed in March at 19.2%.

This softer CPI report aligns with my expectations of a less hawkish policy update from the BoE during this afternoon meeting. It may even lead to speculation that the BoE could leave interest rates unchanged. Currently, the UK rate market is factoring in approximately 14 basis points of rate hikes, down from around 20 basis points prior to the release of the CPI report. This suggests that the likelihood of another 25-basis point hike today is now perceived as a closer call. At the very least, this development adds to the mounting evidence of weaker economic activity data in Q3, and the less hawkish remarks made by BoE Governor Bailey and Chief Economist Pill, which were already pointing towards the BoE signalling tomorrow that they are nearing the conclusion of their current hiking cycle. In line with this, my outlook maintains the expectation of one final 25 basis point hike, culminating at 5.50%.

GBP IS GIVING BACK GAINS FROM THE 1H OF THIS YEAR

Source: Bloomberg, Macrobond & MUFG Research

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