Fed abruptly opts for fighting inflation: dollar flies up

The Federal Reserve made it clear at its December meeting that it is increasingly concerned about inflationary pressures. The dollar reacted to this news as expected, with gains against all other G10 currencies. The Bank of England unexpectedly raised interest rates, causing yet another whipsaw in the markets. The British pound joined the greenback's rally. Most emerging market currencies outperformed the G10 currencies against the dollar. This is an interesting development, which is worth keeping a close eye on. The Turkish lira was once again the exception to the rule: the exchange rate of that currency fell sharply, by more than 15%. Erdogan's policies threaten to ruin Turkey's financial system.

Central banks' priorities have shifted sharply in recent weeks. The Fed has become hawkish, the Bank of England has unexpectedly raised interest rates, and a dissenting voice is being heard within the ECB board. In the run-up to the holidays, there will be little news. Trade will mainly focus on the news about the Omicron variant of the coronavirus. Until the new year, trading on the foreign exchange markets will mainly be determined by the differences in the pace at which central banks adjust their policy. Below are the main currencies in detail.

Euro

The ECB is clearly lagging behind its global counterparts in this round of tightening. However, we do see subtle but clear signs that the institution is starting to change its view on inflation and become more hawkish. Inflation expectations were revised upwards considerably. The Omicron variant was also mentioned as a possible cause of additional inflation. Finally, President Lagarde hinted that there is a group of dissenters within the Governing Council – admitting that the decision was not unanimous. For the time being, however, Lagarde continues to insist that a rate hike in 2022 is 'highly unlikely', which is why the euro has not been able to recover all week.

British Pound

Inflation in the United Kingdom in November, which was higher than expected at 5.1% year-on-year, was another nasty surprise. This may have prompted the Bank of England to raise interest rates suddenly. The vote was remarkably hawkish: 8 to 1. The bank specifically justified this move with references to the tight labor market and inflationary pressures. New data are now scarce and the news from the central bank is positive. Moreover, the market is still very short and positions may have to be hedged in the news-poor period around the holidays. Given all this, we think there is plenty of room for the British pound rally until the end of the year.

U.S. Dollar

As expected, the Federal Reserve doubled the pace of the taper: it will stop buying bonds by March at the latest. However, the Fed's announcements, and especially the 'dot plot' (the point cloud with the individual interest rate forecasts of the Fed members), were 'hawkisher' than most had expected. Fed members now expect to raise rates three times in 2022, and it's clear that a rate hike at the March meeting is a real possibility. Chair Powell indicated that the central bank is now much more concerned about inflation than at the previous meeting, and that it believes that the labor market is close to full employment. We remain broadly positive on the US economy, but a key area of uncertainty remains what will happen to US yields after the end of the Fed's large-scale support for government bond markets (government bond purchases will end in or before March next year).

By: Enrique Diaz-Alvarez

Enrique Diaz-Alvarez is chief risk officer and heads Ebury's analyst team in New York. Because of his drive, passion and thorough knowledge, Enrique is recognized by Bloomberg as one of the most accurate predictors of market movements.

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