FX daily: Bond vigilantes may be the Dollar’s best friends

US real yields and the dollar dipped on yesterday's FOMC, where a somewhat confusing press conference led investors to conclude that the Fed was trying to avoid tightening. But the sell-off in the long end of the Treasury market, pushing mortgage rates to new highs, will keep the Fed on its guard. Look out for US PCE inflation, eurozone GDP and the BoE today.

USD: Lots of focus on real yields

Last night's FOMC press conference was a little confusing. Looking at the market's reaction, the conclusion was that the Fed was not going to be as tough on fighting inflation as initially thought and might try to wriggle through this period of high inflation without hiking. Chair Kevin Warsh's celebration of higher real yields and the more 'direct' message from the markets was taken as a view that the Fed had outsourced monetary tightening to the markets, reducing the need for hikes. To be honest, we are not sure if that is the correct read or whether Warsh implicitly acknowledged that higher real rates embodied an expectation that the Fed would hike in September.

But the market reaction clearly reflected a Fed potentially going soft on inflation, with a huge 14bp steepening in the 2-30 year Treasury curve and US 30-year mortgage rates pushing above 6.70%. Break-even inflation rates derived through the 5Y5Y inflation swap rose 6bp as well.

Having risen 60bp since the June FOMC meeting, two US real yields fell 7bp yesterday and undermined the dollar. Presumably, we will not receive much of a steer from the Fed before its September meeting, and it will be the data which determines whether the Fed will hike. Bond vigilantes could also have a say as well, if a sell-off in the long-end accelerates and the Fed is forced to anchor the short-end with a hike.

For today, the focus will be on the first look at 2Q GDP data (expected at 2.0% QoQ annualised) and the core PCE inflation data for June. The latter is expected to have slowed a little, with core PCE at 0.2% month-on-month and the year-on-year rate dropping to 3.3% from 3.4%. Any downside surprises here could hit the dollar given the emerging view that the Fed is trying to avoid tightening.

DXY probably risks a correction back to the 100.50 area and the two sets of CPI prints and jobs data before the 16 September FOMC meeting will determine whether DXY has topped for the year.

EUR: GDP and CPI data in focus

EUR/USD enjoyed a modest bounce after the Fed press conference, but probably got caught in the crosscurrents. The drop in short-dated US real yields was a clear EUR/USD positive, but the sell-off in long-dated US rates and the pressure it put on growth stocks in the S&P 500 probably capped the EUR/USD move. Ultimately, the ING house call is that the Fed does not hike in September and EUR/USD ends the third quarter near 1.17. But high energy prices and a strong US economy make that Fed decision in September a very close call. Over the shorter term, we expect EUR/USD probably to trade out a 1.14-1.15 range and take its cue from the data.

Europe today will see its first look at second quarter GDP prints and also indications of July inflation. Weak growth (the eurozone is expected at 0.2% quarter-on-quarter) probably will not stand in the way of an ECB hike in September, which is more than 90% priced. An uptick in July inflation data today and high oil prices should keep short-dated euro rates supported.

GBP: Focus on a 7-2 BoE hold today

The Bank of England is widely expected to keep rates on hold at 3.75% today. A 7-2 vote for unchanged rates is consensus and new inflation forecasts should support the doves. The BoE is probably not under as much pressure as the Fed to hike and as tightening expectations fade later this year, sterling should gradually weaken. EUR/GBP could make a run at 0.8600/8610 today.

CEE: Growth data and Fed signals keep FX in focus

Today brings the first hard CEE data of the week, with flash 2Q GDP estimates from the Czech Republic and Hungary. We expect Czech GDP at 0.5% QoQ and 2.1% YoY, versus 0.2% QoQ and 2.2% YoY previously, signalling stronger sequential momentum despite slightly softer annual growth. In Hungary, we expect GDP to rise to 1.2% QoQ and 2.4% YoY from 0.8% QoQ and 1.7% YoY, pointing to stronger activity than earlier estimates implied and supporting a more constructive growth outlook.

Yesterday’s Fed meeting delivered mixed signals for EM: a weaker US dollar on the one hand, but a sell-off at the long end of the curve on the other. We think the initial reaction in EM and CEE should be stronger FX, with the softer dollar dominating for now. The rates impact is less straightforward. Firmer FX should help anchor the front end, while the long end may face pressure from higher long-term US rates. As in the US market, this points to a steepening bias in CEE, especially where central banks are dovish, namely Hungary and Poland.

For now, markets can still take some relief from FX, with EUR/HUF back below 362 and EUR/PLN below 4.320.

Read the original analysis here