FxWirePro: More Hawks in FED Rates Likely to Weigh in Volatile Dollar, OTC FX Substantiates
Potential reassessment of Fed rate hikes by the market: While market implied probability still indicates no Fed hike before 2017, we think there could be some nervousness and volatility ahead of the 14-15 June FOMC meeting. Some Fed officials recently called for two rate hikes this year, including one in June or July.
Meanwhile, economic news flow is now more likely to surprise on the upside after the sharp downward revisions to 2016 GDP growth forecasts seen over the past year (the consensus has moved from 2.8% a year ago to 1.8% currently).
Furthermore, inflation has bottomed out - core CPI is now above 2% - and the base effect from the rebound in oil prices will push it up further in coming quarters. In this context, the market could move towards our scenario (our Fed watcher expects one 25bp hike in December this year).
We are talking about a 25bp hike after all: the Fed will remain significantly behind the curve, as it has been for the last few quarters. This is clearly part of the explanation behind the recent US dollar weakness - decreasing Fed expectations and the economic surprise indicator heading south since April - as US real rates took the driver's seat.
We believe that a slightly more hawkish repricing by the markets would be likely to result in greater volatility rather than market disruption.
The market has a rather complacent view of a moderate repricing of hike expectations: With the 10Y bond yield trading close to the bottom of the 1.65-1.95% range over the past few months, there is a risk of a significant pick-up in volatility.
Furthermore, we don't think the Fed would want to be back at centre stage as a trigger for risk-on/risk-off moves.
As a result of all these speculation on Fed's easing cycle, you can very well observe from the IV nutshell as to how OTC FX markets are gradually pricing in and stabilising over the longer period of time.
Markets are more than ever starving for yield, with €2,900bn of negative yielding sovereign bonds in the euro zone and the current low real rates environment.
Vols in EURUSD seems to shrugged off the looming Brexit/Bremain vote, as it doesn't seem like an ideal time to revolve out of equities.
While Brexit risks seem largely priced into sterling options as polls predict a very narrow result, the odds of the event causing heightened euro-dollar volatility are still off investors’ radar.