- The Federal Reserve is set to taper its bond-buying scheme, and the reaction depends on the details.
- Commodity currencies are better positioned to benefit from a dovish decision.
- The yen and the euro are in a weaker spot while the pound could play a contrarian role.
Taper is coming – so far without a tantrum in markets, but they are undoubtedly set to react. The world's most powerful central bank creates $120 billion every month and this is about to decrease. The questions are: when, at what pace, and when will the Fed begin raising rates?
See Fed Preview: Five dollar-moving things to watch out for on the historic tapering announcement
While the dollar is set to rise or fall across the board, reactions will likely vary, depending on counterparts' own central banks and the nature of the decision. Here is a ranked list of currencies and their potential reaction to the Fed:
1) Canadian dollar – all the ingredients to rise
The loonie is lonely at the top of potential reactions to the Fed. Why? The Bank of Canada has already jumped the gun by cutting short its tapering process and signaling it would raise rates sooner.
Canada also enjoys lower covid cases and higher oil prices. Estimates suggest demand for black gold has reached pre-pandemic levels while OPEC+ countries are hesitant to cut short their output reduction.
The Canadian dollar is the best-placed currency to benefit from a dovish Fed decision. It is also likely to weather a USD storm better than others.
2) Australian dollar – to surge on Fed pushback
The Reserve Bank of Australia has already spoken out this week, pushing back against market expectations to raise rates in 2022 by saying it expects a hike to occur in 2023. That sent the Aussie down. However, it did succumb to bond vigilantes by abandoning its 2024 rate rise goal.
The Australian economy is doing well and rates could still rise next year, however, it depends more on the Chinese economy, which is struggling with several issues, contrary to the rapidly growing US economy on which Canada depends.
AUD/USD has room to rise if the Fed follows the RBA by pushing back against market expectations. While the Aussie could trail the loonie, it would still be one of the big winners. If Fed Chair Jerome Powell refuses to react to market pricing, however, the Aussie is likely to struggle against the greenback.
3) British pound: it's complicated
Similar to Brexit negotiations, the British pound will likely be a mixed bag when it comes to reacting to the Fed decision. The main reason is the upcoming Bank of England decision on Thursday – with markets unsure if a rate hike is coming or not.
See BOE Preview: Guide to trading critical Super Thursday with GBP/USD, in three stages
GBP/USD could react counter-intuitively: if the Fed is hawkish, investors might think this will embolden the BOE to hike borrowing costs now, causing sterling to overperform its peers; on the other hand, if the Fed pushes back against an early rate rise schedule, the "Old Lady" could follow with a cautious approach leading the pound to underperform its peers.
Overall, sterling could be a contrarian.
4) Euro: Lagarde's mixed message undermines the currency
EUR/USD will likely struggle in response to any Fed decision. The European Central Bank doen't want to raise rates until 2023, according to President Christine Lagarde comments early on in the post-rate decision press conference. However, she later refused to push back against market expectations, sending the euro higher.
When the dust settled, it appeared that the ECB remains dovish after all – Lagarde was advised not to argue with bond vigilantes.
Apart from central bank speculation, the old continent is suffering from a new wave of covid cases, especially in the largest economy, Germany.
EUR/USD will likely fall sharply on a hawkish Fed decision and barely rise in response to a dovish one.
See ECB Quick Analysis: Trio of inflation excuses, pledge to print, liftoff rejection are EUR-bearish
5) Japanese yen
Out of all the currencies mentioned above, inflation is the lowest in Japan. Moreover, the Bank of Japan is the most dovish central bank. The safe-haven yen will likely suffer even on a dovish Fed decision, as the upbeat mood in markets would weigh on the currency.
If the Fed is hawkish, safe-haven flows are unlikely to counter the impact of rising US Treasury yields – which trade in tandem with USD/JPY.
All in all, it seems like a lose-lose situation for the yen.
Conclusion
Not all currency pairs are born equal and each is set to react differently to the all-important Fed taper decision.
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