The US Dollar forged an incredible advance heading into the Federal Reserve’s May announcement. The central bank said it would dramatically escalate its monetary policy regime by hiking its benchmark lending rate range by 50 basis points and kick off a program to unwind its massive balance sheet. The Greenback earned its rally.
For investors wondering where it goes from here, there’s an adage: buy the rumor, sell the news. The markets are already accounting for a chasm between the Fed’s monetary policy versus its primary dovish counterparts – the Euro and the Yen. Yet, that divergence will not continue forever. When the gap starts to slowly close, serious reversals may be in store for EURUSD and USDJPY
Basics of Monetary Policy
When it comes to the major fundamental influences on foreign exchange markets, the most consistent drivers tend to be macro considerations such as relative growth or the flow of trade from one country to another. While both are elements to current price action, the most potent driver of currencies is the market’s forecast for monetary policy.
On one extreme, we have ‘dovish’ policy which sees central banks lower short-term interest rates and expand stimulus programs. At the opposite extreme is a ‘hawkish’ regime whereby interest rates are rising and stimulus is shrinking.
All else being equal, a dovish policy pushes a currency lower and a hawkish policy encourages it to rise.
The Hawks Take Off
In 2022, hawkish policy has spread to more of the developed world’s monetary policy authorities. The shift has exacted a considerable burden on the risk-favored capital markets.
To assess the impact of this same evolution on the foreign exchange market, consider the relative position of the two currencies that make up a pair. Let’s start with the greenback. It is influenced by the Fed, which is expected to lift the benchmark interest rate to 2.83 percent by the end of the year along with instituting balance sheet reduction, aka ‘quantitative tightening.’ If the USD is paired against a currency offering a dovish contrast as with the Japanese Yen backed by the Bank of Japan, the market will favor a rise in USDJPY. That is what has happened – particularly in the past two months as the Fed has noticeably escalated its signal.
What Comes Next?
If interest rate expectations stretch too far in a given direction, it is possible that a realized hawkish update from a policy authority can lead a currency to retreat. Or, conversely, outstretched expectations for a dovish move can unexpectedly trigger a rally. Take the aftermath of the FOMC May 4 announcement of a 50 basis point rate hike. This was the first time in 22 years that the central bank had raised by that large a margin. By all accounts, it was a very hawkish move. Yet, after the event, not only did the Dollar not rally on the hike; but it in fact fell sharply when Fed Chairman Jerome Powell pushed back against a question as to whether the bank would consider a 75 basis point hike in the future. So, even though the Fed posted a big hawkish upgrade, the market had over-extended its expectations and the greenback dropped sharply after the headlines crossed.
Buy the Rumor, Sell the News
The market adage certainly applies to currency trading. If one of the most hawkish central banks can urge the currency to slide despite a distinctly hawkish move, the same can happen at the other end of the curve.
There are two major currencies saddled with a dovish backdrop: the Euro and Japanese Yen. The Euro is the world’s second most liquid currency, and its 2022 slide in value has been significant. EURUSD is on the cusp of pushing to lows not seen in 19 years.
Eyes on July
It would be reasonable at this stage to say markets have priced in much for the Dollar and a hawkish Fed, and a significant discount to the Euro via its dovish European Central Bank. Yet, there is rhetoric lately from more than a few ECB members that supports a rate hike by summer or early fall, perhaps as early as July. If speculation ramps up for the move, I don’t think the market has accounted for the competition for rates. Should it be considered a certain probability for a rate hike in the early second half, a reversal from EURUSD above 1.0650 or even 1.0800 could form. A sustained rally would need to come from a persistent closing of the hawks vs. doves policy gaps. This is unlikely, but the initial short-term speculative adjustment can give rise to opportunity.
Reversal for USDJPY?
Another currency that is perhaps even more loaded for reversal opportunity is the Japanese Yen. In approximately two months, USDJPY advanced an incredible 14 percent. That is a remarkably consistent move for so liquid a cross. Pitting the Fed’s tightening effort against the Bank of Japan’s reiterated commitment to keeping its benchmark 10-year government bond anchored – makes for a distinct contrast. The rhetoric from the BOJ is clear, but that is why the market is unlikely to have accounted for much (if any) of the market move should the central bank look to close the gap with Western normalizing programs. USDJPY is in the midst of a 9-week advance, matching only a handful of such rallies in the history of the exchange rate. This situation is quite the staging for any remarks that indicate policy is shifting to hike Japan’s presently negative rate.