FX Update: Market leaning too hard for Fed deceleration?

FX Trading focus: Market pricing a dovish hike from the Fed.

The market appears priced for “dovish hike” from the Fed tomorrow, with a 75-basis point hike fully priced for the meeting, but the path thereafter having received a sharp adjustment lower after the June FOMC meeting, with the downdraft in US treasury yields late last week taking us back to the lower range of Fed expectations for the cycle since that June meeting. It is too early for the Fed to pivot on policy guidance, even if wants to retain some flexibility after today’s hike takes the Fed to the cusp of the highly theoretical “neutral rate” of 2.50%. The market figures that about 100 basis points of further tightening are likely through the December meeting – with more than half of that coming at the September FOMC. Perhaps more important for market outcomes, the Fed’s QT is theoretically set to accelerate on schedule and won’t reach its maximum level until the end of next month, but the four weeks from June 22 to July 20 only saw a $35 billion reduction in the Fed’s balance sheet, slightly only a third of the pace of $95 billion/month set for September. Signs point to continue USD strength until the Fed relents, and it looks too early for that to transpire here on the same month that the official CPI data series reached a new 40-year high.

But the Fed is only one of the market’s many irons in the fire, with the power/natural gas situation in Europe the most pressing issue for any economic region as discussed in the EURUSD chart caption below. Taking the USD out of the equation, if the Fed fails to inspire much of a reaction in longer yields, the EURJPY looks far too high here on a yield spread basis even if Japan is to a very considerable degree also pressured by the natural gas price situation (Japan actually consumes more total natural gas than Germany, even if current), as LNG cargoes are priced with only about a 30% discount to the latest, very high 1-month forward prices in Europe. And, of course, EURCHF already got the memo – trading to new lows for the cycle today.

Chart: EURUSD
The sword of Damocles is hanging over the Eurozone economy in the form of Putin’s threat to further reduce gas flows through the Nord Stream 1 pipeline after these were halved yesterday from levels that were already driving fears of an energy calamity this winter. It was surprising yesterday that the euro didn’t more immediately react to the latest natural gas flow reductions. Yesterday’s July German IFO release saw the Expectations component dropping 5 points to the second worse reading since 2008, only exceeded by a single month during the 2020 pandemic outbreak, and a Eurozone recession looks inevitable without a drop in power and natural gas prices for Europe. Even if the FOMC merely delivers as expected, EURUSD may be ready to probe back toward parity, with a significant test below that level in sight if the Fed entirely fails to indicate a less hawkish shift and Putin tightens the natural gas noose (yes, I am mixing metaphors…). Certainly, the upside resistance at 1.0250-70 is well etched here, with parity merely a psychological downside level.