Spectrum FX Daily Report

Federal Reserve hikes interest rates by 75 basis points

This week is all about major central bank announcements, which are are leading to no shortage of volatility in the FX market.

Attention yesterday evening was squarely on the Federal Reserve that, as expected, raised interest rates by 75 basis points - the largest hike since 1994. The decision to raise rates was unanimous, although one member of the committee did vote in favour of a smaller 50 basis point move. During his press conference, chair Powell indicated that another king-sized 75 basis point move was possible at the next FOMC meeting in July. He did, however, temper expectations somewhat by saying he didn’t expect such large moves to be common. The Fed’s ‘dot plot’ was also shifted higher than we had anticipated. The median dot for year-end was increased to 3.4%, i.e a range between 3.25-3.5% (up from 1.75-2% in March). This implies Fed members see another 175 basis points of hikes at the remaining four meetings in 2022.

In raising interest rates by 75 basis points this week, the Fed has backtracked on its previous statement that such a large hike was not something it was considering. That said, the May US inflation report has clearly forced the FOMC’s hand, and a bold, statement move was perhaps viewed as necessary in order for the Fed to convince markets of its seriousness in reining in the surge in US prices. Markets see another 75bp hike in July as likely, although we think they will revert to a 50bp one, provided we see signs of a flattening out in inflation. This would allow for three, or perhaps even four, additional 50 basis point hikes through year-end. Interestingly, markets reacted in a rather muted fashion to the announcement, albeit the US Dollar Index continues to trade near its strongest position in almost 20 years.

Earlier on Wednesday, the European Central Bank surprised the market by announcing that it was holding an emergency meeting in order to discuss the state of the European bond market. While the prospect of additional action designed to ease fragmentation concerns initially buoyed the euro, in the end the ECB announced very little. In a statement following the meeting, the bank said that it would tilt reinvestment of maturing debt to more indebted members, i.e those in the European periphery. It also noted that it was working on a new tool to deal with fragmentation, although markets were underwhelmed by the complete lack of details provided, and EUR/USD actually ended yesterday lower than where it began it. In other news, the Swiss National Bank bowed to reality by raising interest rates 50 basis points this morning in an out-of-consensus move. The Swiss franc rallied by around 2% on the euro in response, particularly given the SNB appears open to additional moves at upcoming meetings.

Focus now shifts to this afternoon’s Bank of England meeting. As mentioned in our BoE preview report, We expect the MPC to raise interest rates by another 25 basis points today. While market participants are overwhelmingly in agreement that another rate increase is on the way, there is a great deal of uncertainty as to the future path of policy during the remainder of the year. In light of the ongoing inflation overshoot, we expect to see at least a modest hawkish tilt in the MPC’s rhetoric that signals a commitment to additional rate hikes at subsequent meetings. We also expect a handful of members to vote in favour of a 50bp hike, which could be bullish for GBP. We think that even a modest hawkish tilt in the MPC’s communications, combined with a handful of votes in favour of a 50 basis point rate hike, would be supportive of the pound, which looks oversold at around the 1.21 level on the dollar.

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