US dollar retreats as market cools Fed rate hike bets

A continued improvement in risk appetite saw stocks rally and high-risk currencies appreciate against the US dollar on Tuesday.

Long-dated US Treasury yields have continued to march higher in the past few trading days as markets bet that higher inflation is here to stay for some time yet - the 10-year yield is now around a four-month high of 1.65%, up around 16 basis points for the month. While that would ordinarily be a positive for the greenback, short-dated yields have retreated from their highs as investors pair back expectations for Federal Reserve interest rate hikes. The FOMC has indicated in no uncertain terms that it will only start raising rates once it is done tapering its asset purchase programme, and with that looking likely to finish around mid-2022, we may have to wait until the second half of next year for a lift-off in rates.

At the same time, investors are becoming increasingly confident that the Fed’s major peers will be in a position to hike somewhat sooner. According to futures markets, central banks in the UK, Canada, Australia, and even Sweden are now on course to raise interest rates before the Federal Reserve, which is applying a bit of downside pressure on the US dollar. Central banks in New Zealand and Norway have already begun normalising rates and look set to increase borrowing costs at a much more aggressive lick than the Fed in the coming year. With no major economic data out of the US until Friday’s PMI numbers, expectations for the timing of hikes will likely continue to dominate the narrative in the FX market during the remainder of the week.

Sterling hits fresh highs as markets bet on November rate hike

One of the G10 currencies that has benefited disproportionately from the dollar sell-off has been sterling, which briefly rose back above the 1.38 level on Tuesday for the first time since mid-September. Bank of England Governor Andrew Bailey again made it clear over the weekend that higher UK rates are on the way, and the market was quick to see this as an indication that a hike is on the cards at the next MPC meeting in November.

This morning’s UK inflation data fell short of market expectations, although not anywhere near the extent that would materially alter the BoE’s plans. Headline consumer prices rose by 3.1% year-on-year in September versus the 3.2% recorded in August, while the core rate slowed to 2.9% from 3.1%. Policymakers do, however, expect inflation to top 4% by the end of the year, and futures markets are now fully pricing a 15 basis point rate increase from the BoE when it next meets in a little over two weeks' time. Aside from Friday’s retail sales and PMI figures, we see very little economic prints in the interim that could potentially derail a November hike. We do, therefore, see near-term risks to the pound as skewed to the upside.