FX Daily: A dovish hike ahead of a hawkish hold

The ECB hiked rates yesterday but offered enough hints to convince markets this is the end of the tightening cycle. EUR/USD sensitivity to the dollar leg and – by extension – US activity data should be even higher at this point. Elsewhere, some BoJ members have reportedly pushed back against hawkish interpretations of Ueda’s comments earlier this week.

USD: Starting to gear up for a hawkish Fed meeting

The dovish ECB hike (more in the EUR section below) and another round of strong US activity data sent the dollar on another rally yesterday. US August retail sales rose more than the consensus (0.6% month-on-month), even though the bulk of spending growth was due to higher gasoline prices. When stripped of fuel sales, the print was a more modest 0.2%, although still higher than expected. PPI was also higher than expected, while initial jobless claims were slightly changed (216k to 220k) after last week’s big drop.

With the ECB meeting now past us, market attention will shift to next Wednesday’s FOMC announcement. Evidence of slower disinflation has provided an incentive to keep one hike in the dot plot projections for the end of 2023, while resilient US data may well see a revision higher of the 2024 median plot (currently embedding 100bp of easing). We doubt that sort of adjustment would come as a shock to markets, but would further discourage bearish positioning on the dollar.

Today will see the final bits of data that can move markets before the Fed meeting. The University of Michigan's sentiment indicators are expected to decline, but inflation expectations remain unchanged. Empire Manufacturing is improving, while industrial production should slow down on the month-on-month read. It looks unlikely that these releases can materially affect expectations for next week’s meeting when a hold appears a done deal, and all focus will be on new projections and forward-looking language.

The next resistance for DXY is the 105.85 March high: beyond that, it would explore levels last seen in November 2022. Today is starting on a more risk-supportive tone in FX, as China’s August industrial production and retail sales both surprised to the upside, fuelling expectations that the worst may be behind us on the Chinese data flow. The dollar may correct a bit lower today, but the risks remain skewed towards further strengthening in the near term, or at least until the US activity picture starts to show some cracks.