Investors drove the U.S. dollar sharply higher on Wednesday after the Federal Reserve signaled an earlier interest rate hike. Thirteen out of eighteen policymakers now see as many as two rate hikes by the end of 2023. In March, only seven members saw a move in 2023 with the majority looking for rates to remain unchanged into 2024. This dramatic shift in expectations was motivated by stronger than expected growth and inflation. The improvements in the U.S. economy have clearly convinced policymakers that “inflation could turn out to be higher and more persistent than we expect,” according to Federal Reserve Chairman Jerome Powell. Growth and inflation forecasts were raised for 2021 and 2023. The most dramatic change was in their estimates for core PCE, which was raised by a full percentage point to 3.4% for 2021.
Chairman Powell’s tone at the press conference was undeniably optimistic. He said indicators of activity and employment continues to improve with the factors weighing on employment growth expected to wane in the coming months. He took time to downplay the slow improvements in the labor market, saying that it is clear we’re on a path to a very strong labor market one to two years out. As a result, “many participants are more comfortable” with the idea that “economic conditions” in their “forward guidance will be met somewhat sooner than previously anticipated.”
Powell even addressed taper. The Fed Chair admitted that officials have begun “talking about talking about” slowing bond purchases even though tapering won’t happen until they “feel the economy has reached substantial progress.” “They’ll be able to say more about timing when they see” the data. Ten year Treasury yields jumped 5 percent, reinforcing the rally in the dollar.
The question now is whether the dollar’s gains are sustainable.
Given how long investors have been waiting for the central bank to talk taper and how uncertain they were as to whether it would happen today, we see further gains in the dollar. The Fed’s optimism is a reflection of their belief that economic data will continue to improve in the coming months. The Swiss Franc was hit the hardest by the rally in the dollar followed by euro. The ECB avoided taper talk at their last meeting and that decision weighed heavily in EUR/USD’s performance on Wednesday. The Swiss National Bank meets tomorrow and like the ECB, no consequential changes are expected.
Next to the Japanese Yen, the currency that resisted the dollar’s rise the most was sterling. Inflation in the U.K. rose more than expected in the month of May as the year over year CPI rate hit 2.1%. The Australian and New Zealand dollars come into focus tonight with Q1 GDP due from New Zealand and labor market numbers expected from Australia. Both reports are expected to be strong which should ease some of AUD and NZD’s losses.
Kathy Lien Managing Director of FX Strategy BK Asset Management