FX markets brace for a pivotal Fed decision
Market overview
FX markets head into a busy 24 hours with monetary policy firmly back in control. The dollar remains well supported after five consecutive gains, while sterling is trading cautiously following a largely uneventful UK inflation print and the euro continues to lose ground as higher energy costs, rising bond volatility and softer growth expectations weigh on sentiment. With the Fed decision tonight and the Bank of England following on Thursday, relative rate expectations are once again driving price action across the majors. Broader risk conditions also favour the dollar, with Brent pushing towards $110 per barrel, technology stocks under pressure and global yields moving higher. Unless central banks deliver a meaningful dovish surprise, the current backdrop looks likely to keep defensive demand for the USD intact.
USD: Fed credibility takes centre stage
The dollar index closed higher for a fifth straight session yesterday, its longest winning run since June, as markets position for today’s Federal Reserve decision.
A rate hike is now viewed as close to certain, helped by the sharp rise in oil prices and renewed inflation concerns. With the move largely priced, attention should shift towards the vote split, updated economic projections and the Fed’s dot plot.
A sizeable number of dissenters could temper the dollar reaction by raising questions over how unified the Committee is on the need for tighter policy. Williams and Waller may attract particular attention given their recent comments suggesting a more benign view of underlying inflation.
The projections also carry some downside risk for the dollar. Inflation forecasts could be revised slightly lower, while expectations for the median policy rate in 2026 and 2027 may come in below current market pricing.
Even so, Chair Kevin Warsh’s press conference is likely to determine whether the dollar can extend its recent gains. Any indication that further tightening remains on the table would strengthen the Fed’s inflation-fighting credibility and support the currency.
DXY is consolidating close to its early-September highs around 99.70, with 100.00 an increasingly obvious technical target if the Fed maintains a firm tone.
August US retail sales are also due before the decision, although the response may prove limited given the scale of the policy event later in the session.
GBP: Inflation offers little support before the BoE
Sterling has reacted modestly to August’s UK inflation report, with the figures broadly matching expectations.
Headline CPI rose to 3.1% year-on-year from 2.9% in July, while core inflation remained unchanged at 2.6%. Services inflation eased slightly to 3.4%, below expectations of 3.5%.
Energy and petrol prices were the main drivers of the increase, giving both sides of the Bank of England debate something to work with. Policymakers favouring caution can point to the absence of broader inflation spillovers, while more hawkish members will note that headline inflation is running above the Bank’s previous forecast.
The outlook remains complicated by energy costs. With oil holding close to $100 per barrel and Ofgem’s energy price cap set to rise by 4% in October, the headline inflation rate is likely to remain elevated through the autumn.
Markets expect the Bank of England to hold Bank Rate at 3.75% on Thursday, which would mark a sixth consecutive pause. The data offer little immediate justification for a hike, particularly with no new Monetary Policy Report due until November.
However, a firmer tone from the Bank remains possible if policymakers place greater emphasis on the inflation risks created by higher energy prices. The vote split will therefore be important, after the previous meeting produced a 6-3 decision in favour of holding rates.
Sterling may struggle to generate a sustained rally even if the Bank sounds more hawkish, with markets already pricing significant tightening over the coming months. GBP/USD remains sensitive to tonight’s Fed outcome, while GBP/EUR continues to trade in the upper 1.16s.
EUR: Energy and rates pressure build
The balance of risks continues to deteriorate for EUR/USD. The pair has slipped below its 100-day moving average and is now testing the 50-day measure as investors reassess eurozone growth prospects and the relative outlook for ECB and Fed policy.
Energy remains the euro’s clearest vulnerability. Oil prices have risen sharply this quarter, while European gas prices are also climbing again. The eurozone has absorbed the shock reasonably well so far, but a prolonged rise in energy costs would increasingly threaten growth and household demand.
Bond-market volatility is adding another layer of pressure. The MOVE index has risen alongside global yields, a combination that has historically proved difficult for EUR/USD.
The bigger issue for the ECB is the growing trade-off between inflation and growth. Having already raised rates towards the upper end of neutral territory, policymakers may find it increasingly difficult to justify the amount of additional tightening currently priced by markets if economic activity weakens.
Next week’s PMI data will be important in testing that view.
For now, relative rate dynamics continue to favour the dollar. Unless geopolitical tensions ease or the Fed delivers a clear dovish surprise, EUR/USD remains vulnerable to further downside, with 1.15 a key level to watch.
Looking ahead
Federal Reserve: A rate hike is heavily priced, leaving the vote split, dot plot and Chair Warsh’s press conference as the main drivers for the dollar.
US retail sales: Due before the Fed, although market sensitivity may be limited ahead of the policy decision.
Bank of England: Rates are expected to remain at 3.75% on Thursday, with the vote split and tone on future tightening likely to drive sterling.
Energy markets: Brent approaching $110 per barrel remains an important inflation and FX risk, particularly for Europe and the UK.
EUR/USD: 1.15 remains the key downside level as energy, rates and growth concerns continue to weigh.
DXY: A break above 99.70 would bring the 100.00 level firmly into focus.