USD: Fed can keep offering support
The dollar has retained good momentum so far this week, largely benefiting from safe-haven demand as risk sentiment has remained quite fragile. The performance across G10 currencies continues to follow a textbook reaction to an inverted US yield curve (the 2Y10Y currently oscillating around -40/-45bp), with pro-cyclical commodity currencies getting hit particularly hard.
Yesterday, markets had a chance to look at the last bits of data before today’s FOMC announcement, with a specific focus on housing figures. Housing starts surprisingly spiked in August, while building permits dropped. On the one hand, this continues to raise concerns around this sector, as the rise in housing starts points to more supply at a time when high mortgage rates are set to curb demand. On the other hand, falling building permits suggest this may be the last big wave of construction and supply should ease next year.
In terms of today’s big event, the FOMC announcement, concerns about the housing market will likely play a marginal role. The above-consensus inflation reading in August and recent Fed communication have left little doubt among investors and economists that the Fed will hike by another 75bp today. This is also our call, as discussed in, where we also explore different scenarios and potential market implications.
With somewhat limited scope for a surprise on the size of the rate hike today, all eyes will be on the updated projections, and especially on the Dot Plot estimates. We expect another revision higher in the median Dot Plot so that the terminal rate should now fall in the 4.25-4.50% area in 2023. Revisions to other economic forecasts should show some signs of a worsening economic outlook, but the notion of broad resilience in the US economy should remain the baseline scenario.
Looking at FX implications, we think that a hawkish hike today by the Fed will keep front-end rates supported and a very inverted yield curve should continue to endorse the dollar’s good momentum for now, largely to the detriment of pro-cyclical currencies. With the relationship between short-term rate dynamics and most G10 pairs having waned lately, expect a big chunk of the market reaction to be driven by the reaction in global equities – here a still hawkish Fed may not be read as good news, and that is another reason why we expect the safe-haven dollar to remain bid.