Fed leans toward tightening

The Federal Reserve is clear on setting a path for policy normalization, starting with a tapering of asset purchases that chair Jerome Powell said would begin soon. Markets have generally assumed that tapering will begin from the November FOMC but the dots plot released at the September meeting brought forward the median estimate for rate lift off to 2022. Nine of 18 policymakers on the Fed now see rates going up next year with six of them expecting one hike and three seeing the potential for two.

We accept the Fed’s view that the US economy has cleared enough of a threshold to begin the tapering of asset purchases and to bring them to an end by mid-way through next year. Chair Powell did say in his press conference that only after asset purchases were brought to an end that rates would move higher, to avoid policies working against each other.

The question then for markets is how long the Fed will leave the economy alone after concluding its tapering. Should the Fed proceed on a monthly basis in withdrawing stimulus (cutting its UST purchases by USD 10bn/month and its MBS purchases by USD 5bn/month) they will have brought asset purchases to an end by mid-2022.Powell indicated though that bringing QE to an end was not a “direct signal” to rates going higher although we would expect commentary from hawkish figures on the Fed to lean toward hiking rates sooner than later. In any event, the trajectory for US monetary policy is firmly shifting toward being less accommodative, rather than more, with implications for the currency outlook.

Among the other major central banks, we see no material policy changes coming from the European Central Bank, Bank of Japan or Bank of England, at least in the short term. While the ECB did announce a slower pace of asset purchases at its own September meeting, it is likely to maintain an accommodative stance even once the PEPP comes to an end in March next year. The pre-existing asset purchase programme of EUR 20bn/month appears set to remain in place, and could even be topped up. The BoJ’s meeting earlier this week was largely a placeholder meeting amid political change in the country but nevertheless there appears to be no need for any imminent tightening in the foreseeable future in Japan.

With that in mind we expect to see EURUSD and USDJPY both move in favour of the dollar over the next year, with a EURUSD Q4 2022 target of 1.14 and USDJPY Q4 2022 target of 111. Vaccination differentials seemed to largely set the tone for currency in much of 2021 but we expect more conventional fundamental drivers to re-emerge next year, with inflation and yield differentials favouring the USD in both pairs.

The Bank of England appears torn between wanting to send a message that it is on top of rapidly rising inflation while also accommodating an economy that is showing signs of slowing. Among the major central banks we would expect to see the BoE leaning toward pulling back on stimulus measures at some point in 2022, helping to provide support for GBPUSD with a Q4 2022 target of 1.42.

Among the commodity currencies, central bank officials in Canada, Australia and New Zealand have all begun to signal tighter monetary policy ahead, even if they believe it will be at a slower pace than markets seemingly are expecting. We expect to see steady gains for these currencies against the dollar into the end of next year.

Emirates NBD Research FX assumptions

Source: Bloomberg, Emirates NBD Research