Currency Point: Proceeding as planned – USD

As we laid out last week, the Federal Reserve has given us a playbook into how to trade FX over the coming months – particularly the next three.

All week US bond rates have risen as the market digests where inflation-linked real rates should be, come the start of 2022.

The Fed’s hawkishness has seen the US 2-year government bond yields from 0.27 percent to 0.32 percent at its highest before settling at 0.3 percent come Friday. The US 10-year yields rose from 1.45 percent to 1.57 percent, its highest level in 3 months, it has eased back to 1.54 percent. But, the trend is clear and the communication from the Board all last week is just as clear – Quantitative Easing (QE) will start to be unwound from November.

Here is the Board Communication that mattered from last week:

• New York Fed President John Williams – a voting member and highly influential. Stated: “good progress has been made on the inflation and job goals and hence reducing the pace of bond buying may soon be warranted”. He did also make the separation between QE and lift-off (rate rises) very clear with this line: “conditions to support rate hikes still lie well in the future, with long-term inflation expectations remaining relatively stable.”
• Governor Lael Brainard added her two cents stating she expects conditions in the labour market to be met soon – this will allow bond purchases to be tapered. But was also on point with the Boards comms adding that there are ‘no signals’ that the timeline for rate hikes is near.
• Chicago Fed President Charles Evans was also on the script with tapering: If the flow of employment improvements continues, it seems likely that those conditions will be met soon and tapering can commence, and also rate hikes: Future decisions regarding the path of short-term policy rates seem much less clear to me at the moment, he continues to advocate for a sustainable moderate overshoot in inflation.
• Philadelphia Fed President Patrick Harker also on the script but with some slightly more colourful language said it will soon be time to boringly start tapering. “There is no longer much need for QE since the problems facing the economy are not so much demand as supply.” He went on to state that did not expect lift-off until late 2022 or early 2023. There is clearly an agreement that board members can communicate as they see fit – but must stay on point – QE first then lift off if the high hurdle is being met. The playbook remains – high real yields will attract flows to the USD which is what we have seen already.

We remain strong in the view that EUR/USD and USD/JPY are the most likely pairs to move in sync with the Fed playbook thematics. EUR/USD has moved from $1.18 pre-FOMC to Friday’s $1.1579 is the lowest level for the pair since July last year.

A slide in US Treasury yields on Thursday knocked USD/JPY off its highest read since February 2020 of ¥112.07 back into ¥111.16, but as we stated last week JPY has the highest correlation with US real yields – ¥112.50 and above is very likely in the coming period.