The pound was dragged down by USD strength in the middle of yesterday’s trading session following Russia-Ukraine headlines, but managed to close the day out higher while it also rebounded against the euro after Monday’s lows. Sentiment around the pound remains tentative after Boris Johnson’s office has confirmed that the staff gathered to celebrate his birthday during the 2020 lockdown, adding to existing allegations of rule-breaking parties and other scandals. Johnson is still awaiting the partygate report by Sue Gray, which is expected to be released this afternoon at the earliest. The outcome of the report may spark a no-confidence vote if 54 MPs (15% of the total) submit letters calling for his resignation. So far, there are no signs of the 54 threshold being reached, with Tories strongly supporting his statement on the tensions with Russia over Ukraine. Outside of political factors, rate differentials are expected to be key for GBPUSD today as the Federal Reserve is set to announce its latest policy decision tonight.
The euro continued to weaken against the pound and US dollar in yesterday’s session as the narratives from earlier in the week remained prominent: rising US yields, concerns over a military confrontation in Ukraine and uncertainties around Italian elections. This comes at a time where the eurozone’s inflation has been rising while the European Central Bank remains one of the more dovish central banks in the DM space. The combination of these factors drove EURUSD down to fresh year-to-date lows before the pair recuperated some of its losses in the latter part of the trading session. Outside of these factors, EUR traders watched as ECB Chief Economist Philip Lane stated yesterday that the Omicron variant is not turning out to be a factor that will influence activity levels for the year. He added that there are no signs of a big response of wages to inflation yet. While this may be taken as a positive sign for the economic outlook, Lane’s comment could have actually contributed to the weakness in EURUSD as the limited impact of inflation on wage growth and vice versa weighs on expectations of policy normalisation by the ECB. This drives home the idea that the ECB is the dovish outlier among the G10, which exposes the euro to widening yield spreads as normalisation is set to begin in other parts of the G10 this week. Today’s session is likely to be more muted ahead of tonight’s FOMC rate decision.
Price action in the G10 yesterday was fairly mixed. The dollar remained bid against low yielding currencies, such as EUR, CHF and JPY, while high beta currencies posted a rebound against the greenback after feeling the risk-off pressure for the past week or so. This morning, the dynamics in the G10 space look similar to yesterday despite geopolitical tensions remaining at the fore. Today’s Bank of Canada and Federal Reserve announcements may act as a distraction to the geopolitical developments, however, as volatility is likely to pick up again in the rates space. Expectations are for the Fed to hike rates to 1% this year and for some degree of quantitative tightening to accompany the traditional rate hikes. While there is little expectation that the Fed will hike rates at today’s meeting, the lack of a clear signal from Chair Powell that a 25bps hike will be imminent in March or hints that quantitative tightening may reduce the probability of 4 rate hikes this year will be seen as a dovish development. The Fed’s announcement shouldn’t just be viewed in the context of OIS markets pricing in 4 rate hikes, but also the incremental shift in sell-side analysts’ expectations for even higher rates in 2022 and the turmoil caused in equity markets over the past week due to the pricing of a higher risk-free rate. The Fed is expected to announce its latest policy decision at 19:00 GMT, with Chair Powell speaking to the press at 19:30 GMT.
A retracement in oil markets and a somewhat stabilisation in equity markets helped the loonie recover early losses in yesterday’s trading session. Positivity wasn’t isolated just to CAD as most other commodity currencies also rose against the dollar yesterday after a sustained period under pressure. The loonie has continued to climb higher again this morning as it looks to return to last week’s two-month highs, but a key Bank of Canada decision awaits. Announcing policy at 15:00 GMT/ 10:00 ET, the Bank of Canada is likely to embark on its first rate hike since the onset of the pandemic. Overnight index swaps are pricing a 70% probability of a 25bps hike today, while sell-side analysts polled by Bloomberg are split 16-11 in favour of holding rates. Given the information released last week in December’s CPI report and Q4’s business outlook survey, we expect the Bank to embark on a 25bps hike today, which would be supportive of a loonie rally at the margin. Such a decision would need the BoC to reassess its estimate of potential output lower again, which we don’t envisage as too far fetched given the further Omicron impact and the pressure from inflation on growth conditions. The Bank could strike a more hawkish tone by providing further guidance on rates as they prioritise tackling inflation, discussing quantitative tightening as a likely policy tool in coming meetings, or show greater sensitivity to the current inflationary overshoot. Given the risks are skewed towards the Fed undershooting market expectations and our base case for the BoC to conduct a relatively hawkish policy announcement, we expect USDCAD to continue trading towards last week’s lows should geopolitical factors and equity market volatility allow.