USD: FX reaction will be relatively subdued next week

The key event next week will be the FOMC meeting. MUFG Bank Analysts they believe that Fed Chairman Jerome Powell is ready to reiterate the gradual approach of phasing out QE and increasing interest rates.

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“The US dollar strengthened markedly yesterday with weak risk appetite fueled by current concerns about the impact on growth of supply restrictions and continued regulatory crackdown in China and renewed default concerns following the trade suspension of the Evergrande bonds yesterday. The fragile risk conditions certainly appear to be a validation of the caution communicated by Fed Chairman Powell in Jackson Hole about the beginning of the QE phasing out. We expect President Powell to repeat that if “the economy evolved broadly as anticipated, it might be appropriate to start slowing the pace of asset purchases this year.”

“Our currency correlation analysis confirms that the US dollar is becoming more sensitive to rate movements at the short end of the curve. Short-term rates rose in June after the FOMC meeting saw DOTs surprise to the upside. We do not expect it to be repeated next week. A repeat of the June profile with a similar pace for 2024 as for 2023 would be a relief for the market and would likely see a modest depreciation of the USD. DOTs confirming a median increase in 2022 would generate the largest currency reaction with DXY likely to return to trading above the 93,000 level. A mean DOT of 2022 would clearly undermine Powell’s attempts to break any link between phasing out and rate increases. “

“Assuming no average rate hike is revealed in 2022, we would expect the FX reaction to be relatively subdued next week.”