EUR/USD clutching for support near 1.1286 As hawkish Fed curbs early 2022 reboundPolicy normalisation could accelerate furtherBut an easy-ECB policy far from guaranteed

Image © Adobe Images

The Euro to Dollar rate found support in the 1.1286 area after being bruised in overnight trading when minutes of the latest Federal Reserve meeting confirmed there’s elevated risk of a further acceleration in Fed’s monetary policy normalisation and provided new insight on what this might look like.

Europe’s single currency came under pressure in overnight trading that pushed Euro-Dollar back below 1.13 after minutes of December’s Federal Open Market Committee meeting confirmed that “most participants” felt that the Fed’s preconditions for lifting the Federal Funds interest rate “could be met relatively soon if the recent pace of labor market improvements continued.”

“Many participants” judged the U.S. economy to be fast approaching full employment while “several participants” thought the labour market had already reached its maximum sustainable level of employment, while all agreed that the Fed’s goals in relation to inflation had been more than met in what was a clear indication that conditions could be right for the bank to begin lifting its interest rate over the coming months.

“The FOMC already doubled the pace of tapering December and signaled that it would hike earlier and more often than previously anticipated. It now also suggests that it may reduce the balance sheet earlier and faster than last time (which was two years after the first rate hike) through quantitative tightening, or QT,” says Stefan Koopman, a senior macro strategist at Rabobank.

Above: Euro-Dollar rate shown at 4-hour intervals with Fibonacci retracements of December’s attempted recovery indicating possible areas of support.

EUR/USD reference rates at publication:

Spot: 1.1306High street bank rates (indicative band): 1.0909-1.0988Payment specialist rates (indicative band): 1.1200-1.1250Find out about specialist rates and service, hereSet up an exchange rate alert, here“Even though there was some speculation that the Fed could put a quicker move to QT on the table –as inflation is higher, the labor market stronger, and the balance sheet larger than last time– it still seems to be coming as a surprise,” Koopman said in a Thursday note.

New economic forecasts released after December’s meeting had already suggested the Fed could raise its interest rate as many as three times in 2022, implying a sooner start to the process of reversing 2020’s large interest rate cuts, while last month’s policy decision included a plan to fully wind down the Fed’s $120BN per month bond buying programme by the end of March instead of in June 2022 as had originally been intended.

But the minutes released on Wednesday also revealed a substantial deliberation among FOMC members last month about what to do with the Fed’s balance sheet, which has swelled to more than $8 trillion due to the bank’s mammoth and almost two years long quantitative easing programme.

“Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience ” the minutes state.

{wbamp-hide start}

{wbamp-hide end}{wbamp-show start}{wbamp-show end}

“Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode. Many participants also judged that monthly caps on the runoff of securities could help ensure that the pace of runoff would be measured and predictable, particularly given the shorter weighted average maturity of the Federal Reserve’s Treasury security holdings,” the meeting record also said.

Details of the discussion about “quantitative tightening” suggested the process that would slowly and predictably shrink the balance sheet could commence soon after the point at which the bank begins to lift its interest rate and that this process could proceed faster than in the previous instance when the Fed sought to reduce its holdings of U.S. government bonds and residential mortgage-related securities.

“In the last tightening cycle the Fed started shrinking the balance sheet after the 100bps threshold was met. It took almost two years for the Fed to shrink their balance sheet after the first rate hike in the last cycle,” says Lee Hardman, a currency analyst at MUFG.

“The minutes suggest though that the Fed could even begin to shrink their balance sheet as well later this year. Overall the hawkish tone of the minutes support our outlook for further US dollar strength at the start of this year,” Hardman also said in a Thursday research note.

Above: Euro-Dollar rate shown at daily intervals.

Secure a retail exchange rate that is between 3-5% stronger than offered by leading banks, learn more.

Wednesday’s minutes prompted an almost market wide bid for the greenback, leading the Euro-Dollar rate to come under pressure heading into the Thursday session while stoking confidence among analysts who’re mostly looking for the Dollar to advance further over the course of 2022.

“The minutes understandably spurred risk off in FX and stocks and caused yields to shoot up across the curve. The 10y real US yield has risen by a whopping 26bp to -0.85% since the close on NY eve. It reinforces the chasm between monetary policy in the US and the euro area,” says Kenneth Broux, an FX strategist at Societe Generale.

Europe’s single currency fell more than seven percent against the Dollar in 2021 with much of its decline taking place in the second half of the year after the Fed first began to signal that a withdrawal of the monetary stimulus could be entering the pipeline due to last year’s significant increases in U.S. inflation rates and rapid progress in recovering the employment and millions of jobs that were lost to the coronavirus in early part of 2020.

A part of the reason why the Euro/Dollar rate fell so heavily is because financial markets see little chance of the Fed’s hawkish policy shift being mirrored in Europe or even countered by similar actions from the European Central Bank, although with Eurozone inflation pressures also rising sharply and to record highs in recent months, the ECB could yet surprise the market.

Much still depends for the Euro in the months ahead on whether Eurozone inflation pressures subside of their own accord in the manner anticipated by the ECB, or if they continue to rise in the manner seen in the U.S., UK and other jurisdictions as the latter could potentially compel the market and Frankfurt to reconsider their assumptions about the outlook for interest rates and monetary policy in the Eurozone.