EUR/USD’s recovery a possible inflection point for marketAs Fed's interest rate speed limit may have been reachedECB contemplates hitting ground running on interest rates Amid signs Fed’s policy already having the desired effect

Image © European Union - European Parliament, Reproduced Under CC Licensing.

The Euro to Dollar rate has reversed half of its July decline in a rally that may be an early warning of a market inflection point that would likely provide many currencies with relief from the recently relentless advance of the Dollar.

Europe’s single currency remained buoyant near the 1.02 level against a softer Dollar on Wednesday after stealing headlines previously when Retuers and Bloomberg News reported that this Thursday could yield an outsized interest rate rise from the European Central Bank (ECB).

“Chief Economist Philip Lane will reportedly make the official proposal at the meeting, and markets are now attempting to gauge how many members of the Governing Council would be happy to back such a move,” says Chris Turner, global head of markets and regional head of research at ING.

“Our view remains that even in the event of a hawkish surprise, driving the euro (from a broad-base perspective) sustainably higher remains a hard task considering the worsening growth outlook for Europe,” Turner and colleagues cautioned on Wednesday.

Reports suggested the ECB will on Thursday entertain the idea of immediately ending the era of negative interest rates in Europe by raising its three benchmarks for borrowing costs by 0.50%, which would lift the currently-negative commercial bank deposit rate back to zero.

Above: Euro to Dollar rate shown at 15-minute intervals alongside EUR/GBP.

Any 0.50% rate step on Thursday would be larger than the 0.25% move that was all but pre-agreed by the Governing Council back in June and so may be more effective in limiting the extent to which the ECB risks falling further behind the Federal Reserve (Fed).

But the Euro to Dollar rate had already tested the 1.02 handle previously on Monday after paring away almost half of its July decline in the trading sessions that followed last Wednesday’s U.S. inflation figures, which also have important implications for the EUR/USD outlook.

“At the moment futures markets are pricing in only about 81 bps for the July meeting. These diminished expectations are also keeping the upward potential for 10 year US treasury yields in check and the downward potential for EUR/USD,” says Philip Marey, a senior U.S. strategist at Rabobank.

Last week’s U.S. inflation data was grim for its revelation of a new 9.1% high for the annual rate and a renewed acceleration of the core inflation rate in month-on-month terms, but Fed officials were quick to pour cold water over the idea that this might merit a faster pace of interest rate rises.

"Price action may have understandably spooked them, with frontloading of rate hikes now appearing to come at a cost," says Jonathan Cohn, an interest rate trading strategist at Credit Suisse.

"The perverse nature of frontloading amid recession fears means faster hike expectations often increase overtightening fears, bringing down longer dated yields, which on net eases financial conditions," he added.

Above: Euro to Dollar rate shown at hourly intervals alongside U.S. Dollar Index.

Cold water was poured as three members of the Fed’s rate setting committee quickly suggested the existing plan of raising rates to moderately restrictive levels in only 0.5% or 0.75% increments was still the most appropriate.

“The problem for the Fed is that inflationary pressures are going to be very sticky (most of the impulse is now with services which tends to be less responsive to discrete rate moves) which means that the path back to 2% will be long and drawn out,” says Bipan Rai, North American head of FX strategy at CIBC Capital Markets.

The latest comments from Fed officials drove market expectations for U.S. rates lower and that adjustment was later reinforced when a University of Michigan survey showed consumer’s long-term inflation expectations falling in July.

This is most noteworthy because central banks believe that inflation expectations are self-fulfilling prophecies, and falling inflation rates are exactly what many of them are trying to achieve through their interest rate policies.

“A 100bp hike will be discussed but we think the committee will be reluctant to accelerate the pace,” says Jonathan Millar, deputy chief U.S. economist at Barclays, in reference to next week’s Fed meeting.

But other recent developments have further suggested the Fed may be right to be more circumspect than the market about accelerating the pace at which it lifts interest rates so soon after doing exactly that already back in June.

Above: Euro to Dollar rate shown at daily intervals alongside U.S. Dollar Index and NZD/USD.

These include a growing list of major U.S. companies and captains of global industries who’re increasingly scrapping hiring plans in favour of hiring freezes.

This is exactly what the Fed has been hoping to achieve.

“You have two job vacancies, essentially, for every person actively seeking a job, and that has led to a real imbalance in wage negotiating. You could get to a place where that ratio was at a more normal level,” Fed Chairman Jerome Powell said in June’s press conference.

“You would expect to see those wage pressures move back down to a level where people are still getting healthy wage increases, real wage increases, but at a level that’s consistent with 2 percent inflation,” he added.

While hiring freezes could yet turn to layoffs, they are otherwise evidence of the widely coveted ‘soft landing’ of an economy and job market where supply and demand imbalances have exacerbated the inflation shock stemming from energy and internationally traded goods prices.

This is a materially important context in which future Fed decisions will be made and those are in turn likely to be important influences on the Euro, Dollar and many other currencies during the weeks and months ahead.

Above: Euro to Dollar rate shown at weekly intervals alongside U.S. Dollar Index.

“Our objective, really, is to bring inflation down to 2 percent while the labor market remains strong. I think that what’s becoming more clear is that many factors that we don’t control are going to play a very significant role in deciding whether that’s possible or not,” Chairman Powell also said.

“There I’m thinking, of course, of commodity prices, the war in Ukraine, supply chain [developments], things like that, where we really—the monetary policy stance doesn’t affect those things. But having said that, there is a path for us to get there,” he added in response to a question from the Financial Times.

Most notably, and in short summary, the latest remarks from Fed policymakers are suggestive of the bank having perhaps reached its interest rate speed limit for the time being, and just as the ECB contemplates hitting the ground running when lifting its own rates for the first time this Thursday.

Meanwhile, the Dollar has corrected lower against many currencies for almost five trading days in a row and the European single currency has climbed smartly, while other developments suggest that the Fed’s interest rate policy decisions may already be having the desired effect on the economy.

Analysts would likely disagree at this stage as most hold bullish views on the Dollar and bearish outlooks for the Euro but recent price action is supported by interest rate and inflation developments that are all indicative of a possible inflection point being near for the currency market.