Euro / Dollar Back Below 1.10 in Wake of Brainard Comments, Fed Minutes

Above: File image of the Federal Reserve's Lael Brainard. Image © Federal Reserve.

The Euro has fallen for six days in succession against a rejuvenated Dollar which can count on an even more aggressive pace of rate hikes at the Federal Reserve over coming months.

The Euro to Dollar exchange rate had been close to 1.12 last week as investors started to look beyond the Ukraine war and appeared to have fully 'priced in' an aggressive pace of interest rate hikes at the Federal Reserve.

But it is now below 1.09 following a jump in the Dollar following indications midweek that the Fed might in fact be prepared to ratchet up the pace it intends to raise interest rates and reduce its balance sheet via quantitative tightening (QT).

QT is a process whereby it sells the U.S. government bonds it had purchased under quantitative easing in an attempt to stifle inflation.

"The comeback of the euro was temporary in nature as we expected. The picture looks completely different this week. Last week, EUR/USD approached 1.12 and this week it is below 1.09," says Georgette Boele, Senior FX Strategist at ABN AMRO.

Boele says 10-year U.S. real yields have rallied and are back at the level last seen early 2020 amidst expectations of aggressive rate hikes by the Fed.

Minutes from the Fed's March meeting revealed "many participants" now believe one or more 50bp rate hikes may be warranted in future meetings to combat inflation.

Minutes also indicated that the reduction of the Fed’s balance sheet by $95BN a month (including $60bn of Treasuries) is expected to be approved at the next policy meeting on May 04.

But the Dollar rose sharply against the Euro ahead of the release of the minutes as Federal Reserve Vice-chair-elect Lael Brainard said inflation was "much too high and is subject to upside risks".

Brainard said the Fed’s balance sheet will be reduced sharply as a result, saying:

"The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and [the Fed’s quarterly forecasts]."

The Euro-Dollar exchange rate fell to 1.0875 in the wake of the communication.

"In response, the markets switched from loving risk to loathing it in an instant. Stocks slumped as yields surged higher, which caused the dollar to rally across the board," says Victor Argonov, senior analyst at EXANTE.

Above: EUR/USD daily chart.

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"It is not just that Brainard’s comments were hawkish that sent the dollar sharply higher, but more to the point, it is that she is a known dove. So, her openness to more aggressive hikes suggests that even the doves are turning hawkish, while the more-hawkish FOMC members are becoming increasingly more vocal," he adds.

The minutes to the Fed's March meeting meanwhile showed several members of the monetary policy committee are inclined to back several half-percent rate hikes in the upcoming meetings.

"This hawkish stance of the Fed, whose willingness to move more aggressively than some of its counterparts, such as the ECB and BoJ, is likely to maintain support for the dollar in the run-up to the summer," says Ricardo Evangelista, Senior Analyst at ActivTrades.

Some analysts had been of a view the Fed had already reached a 'peak hawkishness' ahead of the release of the March minutes, thereby offering diminishing returns for bulls.

But, "with the Fed increasingly becoming hawkish, investors have little choice but to pile in on the dollar," says Argonov.

"The greenback is likely to continue its impressive form against currencies where the central bank is either having a tough time keeping up pace with the Fed or is by nature more dovish," he adds.

However some analysts maintain a view that we are near 'peak Fed' and that it will become hard to push interest rate expectations ever higher from the current elevated levels.

Indeed, money market pricing indicates a frantic pace of rate hikes early in the cycle and the potential for rate cuts from 2023, suggesting inflation will be falling by this stage.

It also suggests the prospect for economic contraction next year has grown.

"Powell did throw out an estimate of three years for the length of time that QT is expected to run for a few weeks back, but he’s dreaming in technicolor if he thinks it’ll last that long. The US economy will go into a slowdown and/or recession before that happens," says Rai Bipan, Head of North American FX Strategy at CIBC Capital.

The Dollar's rally would ultimately stall at the point market expectations for the number of rate hikes and the scale of QT reaches a saturation point.

"We expect the FOMC to increase the Funds rate by 50bp in May and June which is now almost fully priced. On balance sheet run‑off, FOMC members noted that it could begin as soon as May," says Kristina Clifton, a foreign exchange strategist with Commonwealth Bank of Australia.

"We think that the USD is near its peak with a substantial tightening cycle priced in," adds Clifton.