Westpac

USD In Focus

An assertive FOMC cemented their hawkish pivot toward mitigating persistent inflation risks with a more aggressive policy normalisation profile.

The lift in the median dot for end-2023 to 1.625% compared to 1.00% in the September update is unquestionably substantial - the FOMC dots are now signalling six 25bp hikes over the next two years, compared to 3 ½ hikes projected in September. There have been just two FOMC dot plot updates going back to 2012 where the median shifted at least as aggressively over a two-year horizon; March 2014 (+75bp) and Dec 2016 (+75bp). • But any potential plot twists were given away ahead of time and markets have taken the prospect of a more aggressive policy normalisation cycle in stride. Chair Powell’s press conference optimism over the outlook would have added to the sense of relief. The dot plot projections for 2024 provide some reassurance too, the FOMC now projecting two hikes in 2024 compared to three in September, meaning there is an element of bringing forward rate hikes - the peak in end-2024 is only modestly higher at 2.125% versus 1.75% projected in September. Q4 US GDP expectations have been trimmed lately, following slightly weaker payrolls and retail sales. The Omicron strain adds to the near-term risks, but the underpinnings for ongoing strong consumer spending are intact – elevated saving, wealth gains and strong incomes growth. Senate passage of President Biden’s $1.75trn Build Back Better plan has been pushed into 2022 and as a result enhanced income support in the form of child tax credits will lapse Dec 2021. DXY likely to encounter some turbulence into year’s end - the hawkish FOMC was largely priced in, positioning is heavily lopsided into year’s end and Q4 GDP expectations under pressure. But the underlying uptrend remains soundly intact. DXY has yet to fully reflect the lift in yield support (see over). The Fed is streets ahead of the ECB too, the latter at pains to push back against market expectations for lift off in 2022 and finding ways to glacially wean the economy off QE support. DXY slippage unlikely to extend much past 95.5, the uptrend likely to resume in the new year, new highs on the cards beyond 97 in Q1 2022.

Idiosyncratic FX stories came to the fore in 2021, RUB, CNH, USD and TWD rounding out the year as the best performers among the G30, a motley crew of currencies if there ever was one.

2021 recap

• CNH outperformance was underpinned by China’s strong external accounts. TWD outperformed despite cross-strait tensions, thanks to booming demand for Taiwan’s semiconductor componentry, while USD gains were fuelled by the Fed’s hawkish pivot.

These themes are likely to extend into 2022 - supply bottlenecks show no signs of abating; the Omicron strain will keep Covid at the forefront; markets are likely to keep a close eye on the pace of booster shot uptake, while central banks will continue to withdraw support. The USD looks well placed to extend its broad bull trend in this environment, the DXY likely to see fresh highs beyond 97.0 in Q1 2022.

• Base effects are likely to drag US annual inflation rates notably lower from Q2 2022, potentially providing some relief for the Fed, but in the interim, inflation is likely to accelerate further still. Owner’s equivalent rent has yet to fully reflect the Covid-related surge in home values and the latest surge in energy prices has yet to fully feed downstream.

Rates markets are roughly in line with the Fed over the next year (3 hikes) but beyond that pricing remains conservative. OIS markets price in a Fed Funds rate of 1.36% by end-2024 versus a median Fed dot closer to 2.125%, a historically large undershoot. Rates markets are even more aggressively priced elsewhere, with 80bp in hikes discounted from both the RBA and the BoE in 2022. But neither AUD nor GBP seem well placed to capitalise on that. RBA Governor Lowe continues to stress patience and insists that hikes won’t be delivered in 2022, while the BoE is unlikely to follow though with hikes while the Omicron strain continues to spread aggressively across the UK.

• EUR and JPY were among 2021’s weaker currencies, their negative yields proving a major headwind in a year of ongoing risk positive conditions. That is unlikely to change in 2022. The ECB remains committed to containing rate hike expectations while the Eurozone labours under a major Omicron outbreak and surging energy prices are cutting real incomes.

• NZD will not resist a strong USD in Q1 2022, but the RBNZ is one of the few central banks that looks set to match market pricing (150bp in rate hikes over 2022), leaving NZD better insulated than most.