USD is attempting to break to upside after hawkish Fed guidance

USD: Scaling back of Fed rate cut expectations providing more support

The US dollar has continued to trade at stronger levels overnight after the dollar index rose to the highest level since the start of August at the end of last week. The dollar index is currently testing the top of the 96.000 to 100.00 trading range that has been in place since Q2. The US dollar’s recent upward momentum was reinforced last week by the hawkish policy update from the Fed when Chair Powell pushed back strongly against market expectations for a another rate cut as soon at the next FOMC meeting in December. He stated that a rate cut in December was “not a foregone conclusion, far from it” which has helped to lift short-term US yields and the US dollar. The 2-year US Treasury yield remains around 5-6bps higher than prior to last week’s FOMC meeting. The probability of another rate cut in December has fallen to around 68% from close to fully priced in a week ago. The change in rhetoric from Fed Chair Powell was likely intended to appease more hawkish voices at the Fed while they await more clarity from economic data releases when the US government shutdown finally ends. Dallas Fed President Lorie Logan and Cleveland Fed President Beth Hammack both stated on Friday that they would have preferred to keep rates on hold. They share a similar view to Kansas City Fed President Jeff Schmid who dissented at last week’s FOMC meeting in favour of leaving rates on hold. They noted that it would be difficult to cut rates again in December unless there is clear evidence inflation will fall faster than expected or that the labour market will cool more rapidly. The longer that US government shutdown goes on the bigger the negative impact on the US economy in  the near-term but Chair Powell has signalled that the Fed would be more inclined to leaves rates on hold in December if they still lack clarity on the performance of the US economy.  

On the other hand, Fed Governor Waller who is one the leading candidates to be the next Fed Chair, stated on Friday that he is “still advocating” a rate cut in December arguing “the biggest concern we have right now is the labour market”. Fed officials are becoming more cautious over lowering rates further as the policy rate moves closer to their estimates of the neutral rate. Chair Powell believes that the policy rate is still “modestly restrictive” but acknowledged that “many estimates of the neutral rate live, in that 3 to 4% area”. The Fed’s hawkish policy update has attracted criticism from the Trump administration. US Treasury Secretary Scott Bessent stated that he applauded the decision to cut rates by 25bps but “the language that went with it tells me that this Fed is stuck in the past. Their inflation estimates have been terrible so far this year. They keep coming down, inflation keeps coming down and their models are broken. And I’m just not sure what they’re thinking here in terms of signalling that they may not want to cut rates at the December meeting. They’ve got a lot to answer for this year but for many years past, both in their GDP estimates and their inflation estimates, which are consistently wrong. And we’re going to find a leader who is going to revamp the entire institution in terms of process and inner workings”. The comments highlight that potential changes to the Fed under the next Chair remain a downside risk for the US dollar next year even if they skip cutting rates in December.                 

GBP UNDERMINED BY DOVISH REPRICING OF BOE CUT EXPECTATIONS

Source: Bloomberg, Macrobond & MUFG GMR

GBP: A dovish hold from BoE but can’t rule out a cut this week

The pound has weakened ahead of this week’s latest BoE policy meeting. EUR/GBP was attempting to break above the 0.8800-level at the end of last week while cable broke back below support from the 200-day moving average at around 1.3250 for the first time since April and then hit a low of 1.3097 on Friday. The pound has been undermined by the dovish repricing of BoE rate cut expectations in October. The 2-year gilt yield dropped by just over 20bps last month. Market participants have moved to price in a higher probability that the BoE will deliver another rate cut before the end of this year. There are currently around 8bps of BoE rate cuts priced in for this week’s MPC meeting and 17bps of cuts by the December MPC meeting. Market pricing has moved more into line with our forecast for another rate cut in December although one can’t rule out another cut as soon as this week which could trigger another leg lower for the pound. The latest price action has supported our long EUR/GBP trade recommendation (click here). 

After communicating to market participants since the summer that they are likely to slow the current quarterly pace of rate cuts, we still expect the BoE to leave rates on hold this week. One weaker CPI report for September is probably not sufficient to force the BoE to go against recent guidance. We assume that the BoE would prefer to see further evidence of weaker inflation and the details of the government’s upcoming Autumn Statement before cutting rates in December. A bigger package of fiscal tightening measures estimated at between GBP30-50 billion which includes less inflationary tax hikes would create more room for the BoE to lower rates. However, the vote for a cut as early as this week could be a close call. We expect Deputy Governor Dave Ramsden to vote for a cut alongside the two most dovish MPC members Swati Dhingra and Alan Taylor. Governor Andrew Bailey could be the decisive swing voter as Deputy Governor Sarah  Breeden has always voted with the governor (click here).  

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com