On the heels of yesterday's Federal Reserve rate hike and a hawkish dot plot, the U.S. Dollar Index is still holding the $100 level. Meanwhile, with benchmark Treasury yields elevated, triple digit oil stoking inflation concerns, and today the Bank of England decision did come out on hold as expected, question marks do remain over how much runway is left in terms of the gains for the U.S. currency.
And joining us live at the open to break down FX dynamics as well as monetary policy is Elias Haddad, BNY and global head of market strategy at BBH's foreign exchange team. Great to have you back. Thank you so much for joining me.
Thank you, Remy. Thank you for having me.
Well, it's been a busy week for central banks, but finally the September Federal Reserve meeting has concluded and we get that rate hike as widely expected. But we did get hawkish commentary as well as those dot plots. So what do you make of the impact of this, and what does it mean for the U.S. currency moving forward?
Yeah, I mean absolutely. The Fed delivered yesterday a hawkish hike. And the market reaction was exactly as you would expect. Dollar rallied. Treasury yields went up. But what was critical here is that inflation, long term inflation expectations, ten year breakeven, dropped. And that's a sign that this hawkish hike from the Fed essentially reinforced the Fed's inflation fighting credibility.
And that's good. And that's why I think it's fairly favorable for the U.S. dollar, at least short term. It was a hawkish hike. The dot plots, obviously, as you pointed out, moved closer to market pricing. Unemployment rate projections were tweaked lower across the board. They also delayed the timing as to when they expect PCE inflation to reach their 2% target by a year.
Real GDP growth was tweaked a little bit higher for the next two years. And more importantly, it's Fed Chair Powell's comments signaling that there's probably more work for the Fed to do in terms of tightening policy to tame inflation.
All that suggests there's probably a bit more tightening in the pipeline that's supportive of the U.S. dollar. And because of the downward adjustment to the long term breakeven inflation rate, that's also supportive for the Treasury market because it reduces the risk that the Fed falls behind the curve.
But with respect to inflation, so bottom line here in terms of the U.S. dollar, the way I see it, the upside is going to be difficult for the dollar to make new cyclical highs because it's not just the Fed that's hiking rates. Other major central banks as well. So this policy divergence story, I would say, is neutral for the dollar to slightly support it because the U.S. still maintains a higher rate than other major central banks.
What is the upside risk for the dollar within this neutral policy divergence setting? It is the fact that the U.S. economy continues to outperform its other major economies. So that skews the risk for the dollar to the upside.
Yeah. And you highlighted a lot of important points here. Because when we're talking about the FX markets, there's macro as well as technical levels. And when we're talking about currency pairs, it's not just the U.S. currency. It's also other economies and their respective currencies. And as you just mentioned, other central banks have to contend with inflation more so than just the U.S., given inflation coming from energy prices.
So we got the Bank of England on hold earlier today as widely expected. But we also have the BOJ. So where do you stand when it comes to rate differentials?
Yeah, it's a great, I mean, that's an absolutely fantastic question. And indeed the BOJ is the next big central bank meeting this week. Bank of England? Not the big surprise. Everybody expected a hold. That's fine. But tomorrow's BOJ is the big thing. And one of the big reasons why the yen has kept underperforming is obviously this.
As you pointed out, this wide rate differential that does not favor the Japanese yen. But also the fact that the BOJ has been slow to tighten policy. So tomorrow is going to be critical to see whether the BOJ either signals a faster pace of tightening. A 25 basis points hike tomorrow is baked in the cake. That's a done deal.
Now the key is how hawkish will that 25 basis points hike be. I think the risk is the market is underpricing the risk of a 50 basis points hike or a jumbo hike tomorrow. But, you know, considering that the bulk of the increase in long term JGB yields has come from a rise in inflation expectations, so it would make sense for the BOJ to perhaps deliver this jumbo 50 basis points hike because it would also help curb the rise in long term JGB yields.
But at the minimum, a hawkish 25 basis point hike should be enough to support the yen. Probably not enough to push dollar yen below recent lows, given that the Fed has also delivered a hawkish hike.
But it should keep the yen within this 153 to 160 range in the near term.
Yeah. And Elias, I know that you not only pay attention to the G7, G10 currency pairs, but you also pay attention to emerging markets. And right now there is a lot happening, as you mentioned, because we are continuing to pay attention to Treasury yields. What's happening in the bond markets, not just here in the U.S. but also overseas.
And we're still having to contend with elevated oil prices despite the recent pullback. We're looking at both WTI and Brent hovering right around the $100 barrel level. And that is something that is based on geopolitics. And as a result, I do want to get your perspective not just on the Canadian currency, the loonie, but what we've been seeing out from the European Commission regarding Canada potentially becoming an associate member.
So what do you make of that situation?
Okay. Well, in terms of the Canada situation, it was still a very long way there. Haven't even ratified the trade agreement between them. I think it moves in the right direction. It's part of Prime Minister Carney's plan from the get go to pivot away from the U.S. It's going to be a multi year, multi decade process.
You're not going to see the immediate market impact right now. But certainly I think it moves in the right direction. It's a structural bullish story for the Canadian dollar. But we're not going to see any immediate reaction at the moment.
In terms of the broader EM market with respect to crude oil, right now we're seeing crude oil prices coming off a little bit after making near multi month highs recently. I think the risk ahead, I think the risk in the short term is that we see that there is a skewed to the upside to crude oil, because Iran has every incentive to hurt the Republicans ahead of the November 3rd midterms.
So that means any pullback in crude oil prices are probably going to be shallow and short lived. And that means, in terms of emerging markets, to me, I like the currencies that have that energy exposure. I like that energy exposure. They have the commodity exposure towards AI or towards the whole new geopolitical landscape. Brazil tops the list there.
Yeah. And finally, before I let you go, you mentioned the midterms. And that is something that all of us are counting down to. And we know that geopolitics as well as politics affect the currency markets as well as the macro. So what is your base case for the U.S. currency as we head into year end?
I mean, the relative monetary policy backdrop will continue to dominate, obviously, the geopolitical tension as well. So that is still supportive of the dollar as well. And you combine that with the relative economic divergence between the U.S. and the rest of the major economies with respect to fiscal policy.
The way I see this, I mean, looking at the polls, it looks like obviously we'll have a divided Congress, whether the Democrats get the Senate. That's still an open question, but there will definitely be more policy gridlock. But that also means there is going to be an incentive for the Trump administration to get through some of their fiscal package ahead before the new Congress or during that lame duck session before the new Congress takes power early in January next year.
But overall, the key point here is that fiscal policy in the U.S. will remain a little bit restrictive. And that suggests to me that the Fed won't have to do a lot more tightening in this environment because fiscal policy is going to be restrictive. So that leaves room for perhaps a downward adjustment to those aggressive rate hike pricing right now from Fed funds futures.
Well, Elias, you covered a lot of ground. So I appreciate your time. And thank you so much for simplifying all of these topics as much as possible today.
Thank you, Remy.
Thank you. Pleasure. Appreciate it.
