Currencies snap back on +1,200 point Dow turnaround

We have not seen this type of volatility in the financial markets since the beginning of the pandemic. The Dow Jones Industrial Average was down -1,115 points in the first half of the NY session but staged a dramatic turnaround to end the day in positive territory up nearly 100 points. With risk appetite driving currency flows it was no surprise to see pairs like EUR/USD and AUD/JPY recover alongside equities.  The U.S. dollar maintained its bid, outperforming most of the major currencies ahead of Wednesday’s Federal Reserve monetary policy announcement. The central bank is widely expected to prepare the market for tightening in March and they could even suggest that it may be necessary to front load tightening.  The prospect hawkishness and risk of a surprise rate hike should the keep dollar bid ahead of FOMC.
 
The recent sell-off in stocks reflects concern about the Fed tightening at a time when the economic momentum is slowing. However after eight straight days of selling and 10% drop year to date, more attractive valuations especially in technology stocks attracted bargain hunters. The hope that risk aversion is easing also helped take currencies off their lows. Looking ahead, V-shaped moves like the one we saw today tends to have at least a day or two of continuation and with the FOMC meeting on Wednesday, the central bank’s guidance will determine whether the bears return. Although the latest consumer spending and manufacturing sector reports disappointed, inflation grew at its fastest pace in December since 1982. The market has fully priced in a rate hike for March with a small chance of a 50bp move. The only question tomorrow is the aggressiveness of the central bank’s guidance. If they suggest that front loaded tightening is necessary or that four rate hikes in 2022 cannot be ruled, stocks could resume their slide sending risk currencies lower and the U.S. dollar higher.
 
One of the weakest currencies today was the Australian dollar which saw PMIs drop to 8 month lows. Manufacturing activity contracted in Australia and service sector PMIs dropped twice as fast as the manufacturing index. Omicron, supply chain issues and a peak in the global recovery are some of Australia’s problems but risk aversion also played a big role in today’s initial decline.  Although Q4 CPI is scheduled for release this evening, the Reserve Bank’s dovish stance should limit the currency’s reaction to a good report. The New Zealand dollar also followed lower despite ongoing strength in the economy. This afternoon we learned that service sector activity accelerated, matching the trend in manufacturing. Fronterra raised its milk price payout which is good for producers. Steady oil prices and the upcoming Bank of Canada meeting (which we’ll discuss more about tomorrow) helped limit losses in the Canadian dollar.
 
Sterling also struggled amidst softer PMIs whereas euro held up fairly well as activity in Germany improved. Although the euro area flash PMI dropped more than expected from 53.3 to 52.4, the decline was due entirely to services as the manufacturing index rose to 59 in January from 58 in December.  Activity in Germany appears unfazed by Omicron with improvements reported in both the manufacturing and service sectors. This reinforces the increase in the German ZEW index and suggests strength for tomorrow’s German IFO report.