GBP/USD Defies Federal Reserve's 'Hawkish' Message

• USD fails to fly after Fed decision
• 50bp rate hike, upgraded rate projections
• Powell maintains 'hawkish' message
• But markets sense the hiking end-game
• "Market isn't buying what the Fed is selling" - BNY Mellon

Image © Adobe Stock

The Dollar strengthened after the Federal Reserve raised interest rates by 50 basis points and lifted its projections of where it expects interest rates to settle at the end of the hiking cycle in 2023.

However, gains were soon relinquished and the Pound to Dollar exchange rate (GBP/USD) returned to levels close to recent six-month highs as Chair Jerome Powell was unable to shake the market conviction that the Fed was in the end-game of its hiking cycle.

"Fed chair Jay Powell did everything he could yesterday to sound as hawkish as possible. And he did not have to rely simply on words to convince the market, he also used the dots, i.e. the projections of the FOMC members' future rate policy," says Ulrich Leuchtmann, Head of FX and Commodity Research at Commerzbank.

The 50bp move was expected, but the hike to the projections was more forceful than was expected and the Dollar rose in the minutes following the release of the decision, confirming a 'hawkish' tinge to the outcome.

Updated projections show members of the Federal Open Market Committee (FOMC) - the interest rate-setting body - now see the terminal resting point for rates at 5.1% in 2023, up from 4.6% in September.

Image: Federal Reserve.

The market's reaction was by no means massive, but stocks nevertheless came off their highs and went into the red.

Another potential surprise to markets was the scope of upgrades to the Fed's inflation forecasts (3.5% vs. 3.1% in September) which is in itself a signal that more hikes are required.

Growth forecasts were also cut as the impact of higher rates and persistent inflation prompted a recalculation of the economy's future path.

Two officials now see negative GDP growth in 2023 as the overall growth projection is lowered by 0.5%.

In a statement, the FOMC said it anticipates ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

Powell said although interest rates are restrictive they are not sufficiently restrictive enough to achieve the Fed's 2% inflation goal.

The statement comes amidst an easing in U.S. financial conditions that results from falling bond yields as investors look forward to interest rates peaking and then falling back.

The retreat in bond yields in turn lowers the cost of finance in the economy, which works against the Fed's attempts to tighten monetary conditions to fight inflation.

Therefore Powell's attempts to sound hawkish would have been a response to these easing conditions.

However, the market ultimately saw through the Fed's messaging and the Dollar retreated back to pre-FOMC levels and stocks recovered.

"Perplexingly to us, forward curves ended the day dismissive of both the Fed’s new dot plot, as well as the hawkish sentiment that characterized the press conference," says John Vellis, FX and Macro Strategist for the Americas at BNY Mellon.

"All his talk and the dots are not doing the trick... the market doesn’t believe Powell and the FOMC. It doesn’t believe that the Fed’s key rate really will be that high by year-end 2023," says Leuchtmann. "It makes sense that neither the dots nor Powell’s press conference had much of an effect on the USD-exchange rates."

GBP/USD fell and then rose in the wake of the FOMC but eased back to 1.2390 at the time of this article's update on Thursday.

This takes international payment rates at the typical bank to approximately 1.2130 according to our data, competitive cash and holiday money providers were offering approximately 1.2257 and competitive international payment providers quoting around 1.2340.

Above: GBP/USD at one-minute intervals showing post-decision price action. Consider setting a free FX rate alert here to better time your payment requirements.

The Dollar remains in a short-term downtrend which extended after data showed U.S. inflation cooled for the second month in a row, suggesting it has peaked.

This has allowed the Fed to consider slowing down the pace at which it hikes rates.

It was this rate-hiking cycle that powered the Dollar higher in 2022, therefore expectations that the end of the cycle is now on the near-term horizon has challenged that rally.

"The statement reiterated the need to take into account the lags with monetary policy works as well, and we expect to see enough progress in cooling activity to require only one additional 50bps rate hike ahead, which would bring the ceiling on the fed funds rate to 5.0%; slightly below the median projection," says Katherine Judge, an economist at CIBC Capital Markets.

Money markets show investors aren't buying the Fed's message: the December-2023 Eurodollar implied yield is consistent with a peak in the Feds rate at 4.5%, well below the Fed's own projection of 5.1%.

Furthermore, two rate cuts are priced in next year after the terminal rate is reached.

"This pricing either reflects the belief that inflation will be slain sooner than the Fed thinks," says Vellis. "Market isn't buying what the Fed is selling."

The Fed has therefore been unable to reset the financial market place and recent trends are therefore likely into year-end.

"We expect US dollar weakness to continue in 2023 given our out of consensus view of more aggressive rate cuts by the Fed in the second half of 2023 than by other central banks," says Georgette Boele, Senior FX Strategist at ABN AMRO.