Despite the debate regarding the significance of the Fed's balance sheet in policy normalization this year, the Fed's communication yesterday focused on the more traditional weapon of rate rises. The FX markets reacted in two ways to the news. To begin with, the statement was rather mild, stating the need to begin tightening soon (March) and a very orderly/passive unwinding of its balance sheet. The dollar was bid against most of the G10 at this point, but the press conference indicated that the Fed could hike at every meeting, putting pressure on currencies in what was a very volatile session.
For today, the market will be interested in a couple of things: a) what was included in the US written response to Russian security demands - i.e., does diplomacy have a chance? and b) 4Q21 US GDP data expected at 5.5% QoQ annualized. Most expect the greenback to continue to remain well supported.
Although no action was taken yesterday, the Bank of Canada made it clear that borrowers will not be given a spring reprieve if the pandemic unfolds as expected. The Bank either decided that a new pandemic wave wasn't the right time to start a rate hike cycle, or it merely wanted to use this announcement to formally stop its forward guidance before pulling the trigger, in what appears to be a tight call. Still, it left no doubts that a rate hike lies in store for March if news on the pandemic and its economic consequences has improved by that point. Yesterday's announcement was only about timing, and market participants are likely to stick to their prior views on the extent of rate hikes and quantitative tightening which should leave the CAD well supported in the medium term.
The EUR/USD is not far from its November lows of 1.1185. The trade-weighted EUR has dropped to its lowest level since February 2020. In addition, the disparity between the USD and EUR two-year borrowing rates has widened to its biggest since February 2020, underscoring the importance of relative monetary trends in driving FX.
So far, the ECB has stuck to the script, saying that a rise in inflation will not prompt them to raise interest rates. Expect EUR/USD to remain under pressure unless something significant happens. For the end of 1Q22, look for a EUR/USD target of 1.10, and for the end of 2Q22, look for a target of 1.08. Furthermore, European currencies are expected to suffer the weight of the tensions in Ukraine. The risk of an interruption in energy supplies, or at the very least a further increase in costs, will harm European business and consumers, while favoring the dollar's geographic and energy independence. Today, the EUR/USD is likely to remain under pressure.
As markets face more broad pressure, the GBP has given up some of its recent gains. The BoE's hawkish attitude, on the other hand, gives some protection against the higher dollar, which will be the trend of the year. While the currency will continue to be under pressure, the pair is expected to trade in a limited range with support around 1.3350/1.3400.