Market Again Allows Fed Rate Hike: Euro Reaction
The euro started the new week on the FOREX market under pressure from the US dollar. The main event at the end of last week was the speech by US Federal Reserve Chairman Kevin Warsh at the annual symposium in Jackson Hole on August 28. His statements turned out to be noticeably more "hawkish" than many market participants expected and provoked a sharp strengthening of the dollar.
Warsh made it clear that the Federal Reserve may again resort to raising interest rates if inflation does not convincingly return to the 2% target level. According to the Fed chief, the regulator "will have to do the work" if confidence in a sustained decline in core inflation does not appear. Thus, the market received a signal that rate cuts are not a predetermined scenario, and the possibility of their increase remains quite real.
How the Dollar Reacted
The reaction of financial markets was almost instantaneous. After Warsh's speech, the yield on US government bonds rose, with the most noticeable increase in the yield of two-year Treasuries, which is sensitive to expectations regarding Fed policy. At the same time, the American currency showed one of the strongest one-day gains in about two and a half months.
The probability of a Fed rate hike at the September meeting, according to market estimates, increased from about 35% to 56%. Subsequently, expectations continued to adjust upward. This became a serious factor supporting the dollar, since higher American rates make dollar assets more attractive to investors.
EUR/USD Came Under Pressure
The main victim of the dollar's strengthening was the European euro. The EUR/USD pair dropped sharply after Warsh's speech and fell to the 1.1578 level. Thus, the market rather quickly revised expectations regarding further divergence in monetary policy between the US and the eurozone in favor of the American currency.
For the euro, the situation is complicated by the fact that investors are simultaneously assessing the prospects for the European economy and future decisions of the European Central Bank. If the Fed does maintain a hawkish stance or begins to raise rates, and the ECB acts more cautiously, the interest rate differential will begin to work against the euro again.
