DB FX Daily: Fed on Hold Has Drawn Smaller EUR/USD Reactions

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FX Daily: Fed on Hold Has Drawn Smaller EUR/USD Reactions

The Fed, ECB and Bank of England are all set to deliver rate decisions this week with the market reasonably confident over the potential outcomes looking for no change in US rates (more on this below), a verbal signal pointing to a likely 25 bp rate hike in June from the ECB and at least 25 bps of tightening from the Bank of England. Perhaps the most uncertainty in the market at the beginning of this week surrounds the Bank of England where the money market has moved beyond pricing 25 bps of tightening to price a small probability of a 50 bp step on Thursday. Our economist continues to see a 25 bp step as the most likely course of action. If the Bank of England were to take a more aggressive path it would likely widen spreads in favour of the pound, and given the recent high correlations between rates and GBP help to boost the pound (see chart at left below). But given the money markets have already factored in further UK rate steps beyond this week, the marginal boost to the pound from an acceleration this late in the rate cycle may be less than seen following the August 2006 and January 2007 rate steps. In addition, large tightening steps could also begin to shift the market focus on downside risks to the UK economy from tightening and limit the gains for the pound in the short-term.

Fed on Hold Has Drawn Smaller EUR/USD Reactions

The Fed is widely expected to leave rates unchanged tomorrow at 5.25% and retain its view towards upside inflation risks in the accompanying statement. Our US economists do note the recent slowdown in some indicators which could influence inflation such as average hourly earnings, unit labour costs, the employment cost index and recent core PCE numbers and are likely to be of some comfort to the Fed on inflation front. But overall economic data since the last FOMC meeting in March has been quite mixed, as detailed in today's US Daily Economic Notes, which our economists believe could lead to relatively minor changes in the Fed's language. Since the Fed first paused in August of last year, FX market reactions to FOMC rate decision have become more modest. EUR/USD trading ranges since the August decision to leave rates at 5.25% have averaged 84 pips (using New York close) with only the January FOMC meeting seeing a range above 100 pips. The previous six FOMC decisions saw an average range of 98 pips and three instances of 100 pip trading days. EUR/USD has rallied on the day of 5 of the past 6 Fed decisions reacting to slight changes in the language with the largest rallies a relatively modest 0.5%. But looking beyond an initial rally, it has been difficult to see a clear pattern emerging from EUR/USD around recent FOMC meetings as shown in the chart at right below.