The US Federal Reserve’s FOMC meeting scheduled for May 3-4 should mark an acceleration in the process of monetary normalization in the US in order to fight inflation (which reached 8.5% in March on a yearly basis and could easily climb to 10% by June). After raising the policy rate by just 25 basis points in March due to the possible macroeconomic fallout from the war in Ukraine, the FOMC is expected to raise the rate by 50 basis points this time, to a range of 0.75% to 1.00%. More rate hikes are to come. A third of market participants expect a 75-basis-point increase in June. All indications are that the US central bank will have to be aggressive to show its determination to fight inflation. Many other central banks, especially in the emerging economies, have already taken this step (we’re thinking of Hungary and Poland in particular). However, in our view, inflation will not abate any time soon. A policy rate hike is generally considered to take between nine and twelve months to feed through to the real economy. Put another way, the US central bank’s March rate hike should not really impact the economy until December at best.
The currency market has a strong belief that rate hikes will be significant in the US in the coming months and will thus support the US dollar. A majority of market participants see US Federal Reserve policy rates rising to 2% by the end of the year - this is an important indication.
The Commodity Futures Trading Commission (one of the market regulators in the US) regularly publishes the positioning of ‘speculators’ in the currency market (i.e., institutional investors including large funds that may have multi-million positions in certain currency pairs). According to the latest figures, the market is predominantly long on the US dollar against almost all major and emerging currencies (chart 1). Many emerging currencies have been rather resilient against the greenback since the beginning of the year (like the Mexican peso and the Brazilian real). This may not last. This data is very useful as it provides insight into the expectations of large institutional investors regarding the evolution of exchange rates.
However, there is an exception: the euro. Recently, net speculative positions on the euro have increased (Graph 2). This reflects a repositioning of institutional investors who are mostly buyers of the euro. The explanation is simple: several members of the Governing Council of the European Central Bank (including Vice-President Luis de Guindos) have argued for an acceleration of the normalization of monetary policy in view of the latest inflation figures. The consumer price index (which measures the impact of rising prices on consumers) reached a painful 7.4% year-on-year in March. The first estimate of inflation for April is due on 29 April. It is clear that inflation will continue to rise, perhaps close to 8% year-on-year. The only way to fight inflation is to raise rates. The foreign exchange market is now forecasting three rate hikes this year in the eurozone. This is optimistic, in our view. But in the short term, it could support the EUR/USD exchange rate. We do not rule out a rebound to the 1.11-1.12 area if rate hike expectations are confirmed. However, we will have to be patient before we have a clear timetable for the evolution of monetary policy in the Eurozone. The next meeting of the European Central Bank is scheduled for June 9 (it is to be relocated exceptionally to the Netherlands). Between now and then, it will be important to keep an eye on the speeches of the main members of the Governing Council: Christine Lagarde, Luis de Guindos Philip Lane (chief economist) and Isabel Schnabel, to name but a few. They could give precious indications on what will be announced in June.