FX Daily: Necessary Evil And Necessary Fixes

As markets price the Fed's peak rate almost at 5.0%, US housing data will be watched this week. A housing downturn is likely considered a "necessary evil" now, but the pace of the drop may start to raise some concerns. In the UK, the new Chancellor will deliver a key announcement today to fix the recent fiscal disaster. Watch for JPY FX intervention today

USD: No Plaza 2.0

Market participants have continued to push their Federal Reserve rate expectations higher in the past week, and Fed funds futures are now almost fully pricing in a 5.0% peak rate for the May 2023 meeting. This marks a full 1% increase in peak rate bets in slightly over a month, largely driven by a firmly hawkish tone in Fed communication, strong labour data and – only last week – core inflation reaching a 40-year high.

If markets are right, and the Fed is embarking on a path to take rates to 5%, it’s hard to see the FX market going in a very different direction than the recent, dollar-dominated one, especially in the near term. The implications of an ever-strong dollar are quite serious for many segments of the global economy, but any attempt to bring this to the attention of US authorities during the IMF meeting in Washington last week was surely unsuccessful. On Saturday, President Joe Biden clearly stated that he is “not concerned about the strength of the dollar”. It’s clear that a Plaza 2.0 continues to look unlikely, with a voluntary devaluation of the dollar looking quite a politically hazardous move by an administration scrambling to contain inflation. If anything, one could speculate that any plan in that direction would only be publicly discussed after the 8 November Mid-term elections.

We don’t exclude that markets will continue to push their terminal rate expectations higher (beyond 5.0%) this week, although the trigger will unlikely come from data. The main highlight this week in the US calendar will be housing numbers. Skyrocketing mortgage rates are surely taking a toll on house prices across the developed world but so far, this is being accepted as a “necessary evil” by central banks. Since shelter represents a third of the US inflation basket, the housing downturn should actually help drive inflation down faster in 2023. House prices fell in July for the first time in 10 years and the consensus is centred around a 7% MoM in housing starts in September.

Our base case for this week is that the dollar will remain supported as the Fed’s determination to take real rates higher, paired with geopolitical and energy-related concerns, may keep risk sentiment on the back foot. We suspect that a break above the 114.70 September highs in US Dollar Index is now only a matter of time, and surely possible by the end of the week.

This morning, Asian stocks are trading lower, following the Wall Street slump on Friday, and only tepidly welcoming the speech by Chinese President Xi Jinping at the ongoing 20th Party Congress, which – as discussed by our China economist here – heavily focused on technology to drive growth and potentially opens the door for less restrictive policies in the longer run. But markets found no hints in Xi’s speech that the zero COVID policy will change or that the Chinese market will become more attractive in the near future. In our view, USD/CNY will continue to rally into the 7.40 level over the coming months.

EUR: Gas Price Corridor On The Way?

The euro should remain heavily impacted by sterling’s swings in the near term, and here the correlation appears to be stronger on the downside: i.e. the spillover from another sell-off in gilts would likely have an asymmetrically larger impact on the euro than the positive implications of a recovery in UK sentiment.

Domestically, this may be the decisive week for EU members to reach a final agreement on coordinated measures against the energy crisis. Over the weekend, a draft indicated that the proposal of a price corridor for wholesale gas transactions was set to be explored: this may be a bridge between the requests for capping gas prices and the concerns that a fully-fledged cap would lead to increased consumption. The content of the coordinated measures could have a more long-lasting impact on the euro than the ECB’s policy direction, at this stage.

On the data side, the ZEW survey and final CPI numbers will be in focus this week. Also, expect to see some interest in Italy’s new government formation, and the choice of key ministers by the new Prime Minister Giorgia Meloni. After failing to convince the European Central Bank's Fabio Panetta to take the role, Meloni looks set to choose Giancarlo Giorgetti as finance minister. He is a member of Meloni’s coalition partner, the League party, and the minister for economic development in the Draghi government. Especially at an early stage, it’s hard to see the new government (and the new finance minister) diverging significantly from Draghi’s reform plans or holding a more controversial tone with the EU as Italy drafts its yearly budget. We don’t currently forecast political risk premium emerging in BTPs over the near term.

We still think that EUR/USD will test the 0.9540 September lows in the near term, and extend a drop below that level by year-end.

GBP: Hunt's Speech Is A Make-Or-Break Event For Sterling

Expect another eventful week in UK markets. Prime Minister Liz Truss replaced Kwasi Kwarteng with Jeremy Hunt on Friday as she scrapped the £18bn plan to avert a corporate tax hike. Hunt will make a statement today outlining the measures he plans to announce in his medium-term fiscal plan due on 31 October. Expect a good deal of volatility around the announcement, as we suspect that general consensus is that the fiscal U-turn will have a much larger scope than corporate taxes.

Quite crucially, today’s announcement by Hunt will coincide with the first day of gilt trading without the support of the Bank of England’s temporary bond-buying scheme, which puts even further pressure on Hunt to deliver a credible plan to fix the UK’s troubled fiscal position. We still think there is a non-negligible possibility that the BoE will at the very least have to postpone its plans to start quantitative tightening at the end of this month on the back of continued instability in the gilt market – even if this is primarily a reflection of Fed tightening and the global backdrop more than domestic developments.

At the same time, there has been increasing speculation that Liz Truss may be forced to leave by an increasing number of Conservative Party rebels. We should get more clarity on this over the coming days; for now, Hunt’s announcement is what truly matters for investors.

Data will also be in focus this week, with CPI figures on Wednesday expected to show headline inflation at 10.0%, and the core rate at 6.4%. This should cement bets on a 100bp hike by the BoE in November.

We continue to see elevated volatility in the pound and mostly downside risks beyond any potential relief rally after today’s announcement by the new Chancellor. We suspect anyway that the government will need to sound very convincing in their fiscal U-turn to bring cable sustainably back to 1.15-1.20. Sub-1.10 levels, also considering our call for a stronger dollar, remains our base case scenario in the coming months.

JPY: More Intervention Increasingly Likely

There is an elevated risk that Japanese authorities will intervene in the FX market to support the yen today as USD/JPY is trading a touch below 149.00 at the time of writing – well above the previous intervention level and dangerously close to the key psychological 150.00 level.

We are not making the argument that there is a clear line in the sand at 150.00 for Japanese authorities (the whole idea of a “line in the sand” in the current FX market appears unrealistic), but it’s likely that allowing a move above 150.00 may well trigger an acceleration of the JPY sell-off which is exactly what Japan is trying to avoid.

Our view is that a prolonged FX intervention campaign in Japan will keep USD/JPY around 150.00 into year-end.

Disclaimer: This publication has been prepared by ING solely for information purposes irrespective of a particular user's means, financial situation or investment objectives. The information does not constitute investment recommendation, and nor is it investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument.