The dollar is weaker after the Fed. The euro, franc and pound still await central banks (Daily analysis 16.12.2021)

The Federal Reserve, faced with inflation at its highest in four decades, made a decisive move to abandon crisis monetary policy instruments rapidly. The dollar gained for a moment, but its strength quickly evaporated, and the EUR/USD pair is near 1.13.

This autumn, the primal cause of emerging markets' troubles has been the growing belief that the Federal Reserve will quickly abandon its crisis policies and begin raising interest rates by the middle of next year. These fears were officially sealed yesterday. However, fear turned out to have big eyes once again: after an initial downward reaction, the stock market on Wall Street rose strongly. The S&P500 index was just a hair away from its all-time high, closing the day at its second-highest level ever.

The volatility of the first reaction might not only be due to the fact that the period had been put on a tightening course, and investors considered the tightening to be a foregone conclusion. Moreover, the year-end is approaching, which is certainly not conducive for investors to engage in new long-term market bets; in fact, positions are usually closed before the Christmas and New Year seasons.

In our currency forecasts, we assume that the dollar has already reached its highs. Interest rates will undoubtedly be an asset for the US currency, rising much faster than in the eurozone in particular. This means that we do not expect a deep discount in relation to the single currency. We expect the exchange rate to rise at the end of March from the current levels of 1.13 to 1.15, which means an increase of less than 2%.

The dollar: the situation calls for action

Both consumer and producer inflation has been at its highest levels in the US for about forty years. Price pressures appear to be becoming common, spreading across many categories of goods and services for good. The central bank has abandoned its assessment that this is a temporary phenomenon - the pain threshold has clearly been crossed. The record price dynamics go hand in hand with the accelerating economic growth. Nearly 6% GDP growth for the whole of 2021 is possible. On top of this, the labour market is heating up and is rapidly heading towards full employment. Companies are facing unprecedented difficulties in filling vacancies. And there are as many as 11 million of them! This must inevitably have an impact on wages.

Such a macroeconomic jigsaw puzzle is causing the Fed to accelerate plans to put crisis tools to rest, despite new epidemic threats. In fact, the prevailing view may be that any restrictions will be a temporary blow to the economy but will cement and exacerbate disruptions in supply chains and make it harder to fight inflation that is getting out of control around the world.

The dollar: the Fed plays hardball in the fight against inflation

As a result, it was decided to accelerate the tapering of asset purchases. Let us recall that initially, it was conducted at the rate of 120 billion USD per month. In January, the scale of purchases will be reduced to 60 billion USD, and the pandemic version of quantitative easing is to be abandoned entirely by mid-March. Initially, i.e. as recently as six weeks ago, it was planned to happen in May.

This will be a forerunner to raising interest rates - a need that is recognised by all policymakers without exception. This is a big change from September when half the Open Market Operations Committee members felt this way. The new forecasts suggest that three rate hikes of 25bp each should be expected next year. Financial markets are now pricing the first hike for May (there is no meeting in April), i.e. immediately after the end of asset purchases. They give it as much as 85% probability. This means that the stage of financial markets becoming accustomed to the shift in the stance of the world's most influential central bank, which causes the most sudden changes of capital, is over. A rate hike will be an advantage for the dollar, but the high bar of expectations threatens a strong reaction in the event of a disappointment.

The euro, pound, franc, Norwegian krone: the currencies still await the central banks' decisions

The Fed's meeting is over, but the next few hours will provide an answer as to how other major central banks assess the risks associated with the omicron. It is safe to say that the monetary authorities are between a hammer and an anvil. It seems that Norges Bank should be the one most willing to look through its fingers at epidemic risks. This would be an opportunity for the Norwegian krone to break out of its weakness. The omicron is hitting oil prices, pushing the EUR/NOK exchange rate away from 10.00. More concern may be shown by the European Central Bank, which is several steps behind the Fed on the path to policy normalisation. And markets are taking for granted the maintenance of an easing stance.

In the case of the Swiss monetary authorities, attention will also be on the approach to the strength of the currency (the EUR/CHF was still under 1.04 yesterday). Once again, the Bank of England's decision will weigh on the knife edge. In November, the monetary authorities postponed the start of the tightening cycle, which strongly undermined the pound's position. A repeat is in the air, which will once again push the pound to the defensive. The counter-argument to a rate hike, despite 5% inflation and a strong labour market, is an epidemic situation. Omicron is becoming the leading variant of COVID-19 in the UK and is spreading at an alarming rate. A new daily record of infections was recorded yesterday, approaching 80 000.