FX Daily: FX market positions itself for stagflation

Yesterday's ECB meeting was a good example of a central bank pushing ahead with policy normalization plans even though growth forecasts were being cut. Central banks are taking the view that higher inflation can no longer be tolerated and are prepared to act - despite the fallout on growth. Looking at bond markets around the world - and the fact that we are seeing bearish flattening - the current focus very much remains on rate hikes and the battle with inflation. We have yet to reach the point where longer-dated yields are falling in a sustained manner on the back of recessionary fears.

We have long held the view that flatter and even inverted yield curves are supportive for currencies. One practical argument is that flatter curves make it more expensive for bond investors to FX hedge their bond investments. But flatter yield curves in a higher rates environment are typically synonymous with central banks starting to press firmly on the monetary brakes - and stronger currencies are generally helpful here too.

What does all this mean for FX markets? Investors will probably prefer currencies where: i) central banks look prepared to deliver on tightening, ii) are less exposed to global growth, iii) are backed by commodity exports to deliver terms of trade gains, and iv) have fewer links to eastern Europe. The dollar ticks most of these boxes, especially if the Fed pushes ahead with tightening at a time when global growth forecasts are being revised lower. European FX remains vulnerable and the outlook is not great either for Asian FX (USD/JPY to 120), hit by higher fossil fuel bills and lower global growth. In short, we can see recent FX trends extending.

Away from Europe, the US focus today will be on the US March Michigan consumer sentiment release. Presumably higher gasoline prices will be taking their toll here. Yet there are no signs of the Fed backing away from tightening - and money markets are actually starting to price a slightly higher terminal rate, earlier. This all looks dollar-positive to us.

DXY has been consolidating near the highs of the year and can push onto the 100 area over the next week.

Yesterday's ECB meeting was taken as slightly hawkish, judging by the 10 tick fall in Euribor contracts (the market now prices a 25bp hike by October) and the big sell-off in Italian debt. Italian debt has also been left a little vulnerable after leaders of northern Europe, meeting in Versailles yesterday, showed little appetite from another round of joint EU bond issuance.

On another day - i.e. pre-war - EUR/USD might have enjoyed lasting gains on ECB hawkishness. Yet it looks unlikely that an ECB, barely matching Fed tightening, can generate a stronger Euro in the face of heavy terms of trade losses. Here we think the surge in energy prices has probably damaged the Euro's fundamental fair value.

EUR/USD can easily drift back to the 1.0900 area today as markets prepare for Fed tightening next week and peace talks in Ukraine do not seem to be making any progress.

The UK has just released some January activity data - all a little better than expected. This will only firm up expectations of a BoE hike at next Thursday's meeting. 30bp of tightening is currently priced. Most of us think that the six BoE hikes priced by the market for this year are way too aggressive. But until the market is disabused of this notion - and this may not take place next week - GBP can probably hold onto its gains.

We favour EUR/GBP drifting a little lower, but remain more worried by GBP/USD. It has failed to recover above previous support levels at 1.3150/3180 and given our strong preference for dollars currently, 1.2850 remains a realistic target near term.

USD/CAD has hovered around 1.28 in the past two sessions after rejecting 1.2900 resistance earlier this week. The correction in oil prices is not taking a big toll on the loonie as it has been largely accompanied by a rebound in global risk sentiment, and crude continues to trade at levels that can further underpin the recovery in the Canadian energy industry. Today, February’s jobs data will be in focus in Canada, and markets expect a rather solid headline read (around 130k), in line with last week’s strong US numbers. Special attention will be on wage growth, which had corrected lower to 2.4% YoY in January.

A good jobs report today could help markets take a more convincing stance on a Bank of Canada rate hike in April, which is currently 60% priced in, and is starting to look increasingly likely given the positive spillover of high oil prices into the Canadian economy and inflation that looks unlikely to abate in the near term. This should pave the way for more USD/CAD downside – the pair could press 1.2700 today - although headlines related to the Russia-Ukraine conflict will continue to play a bigger role for the pair.

Longer term, we expect the Canadian Dollar to be one of the better performers and retain sub 1.25 targets for the second half of 2022.