EUR/USD rallies back above 1.1000 as buck wanes despite hawkish Fed interest rate guidance

• Despite the more hawkish than expected Fed, EUR/USD rallied and is at session highs in the 1.1030s.
• The Fed signaled rate hikes at every remaining meeting this year and four more in 2023, pushing US yields higher.
• But it was risk-on after Powell’s presser and a rally in equities weighed on USD demand.

Though most analysts, economists and commentators were unanimous in their agreement that the latest Fed policy announcement and round of the remarks from Fed Chair Jerome Powell was far more hawkish than expected, markets do not seem to have gotten the memo. The central bank hiked interest rates as expected, with the surprise coming in the new dot-plots, which showed that the median expectation of Fed members is for 25bps rate hikes at all of this year's remaining meetings (i.e. another six), followed by a further four in 2023. That means the Federal Funds rate reaching 1.75-2.0% by the end of 2022 and 2.75-3.0% by the end of 2.23.

Powell’s remarks were suitably hawkish to match the new interest rate guidance and even though this sent US yields higher across the curve, that was not enough to trigger a lasting rally in the US dollar. After dipping as low as the 1.0950s in the immediate aftermath of the Fed’s initial policy announcement, EUR/USD has now been able to recover all the way back to the 1.1030s, where it trades higher by about 0.7% on the day and is eyeing a test of last week’s highs to the north of 1.1100.

Analysts were at a loss to explain why the dollar could hold onto its initial post-Fed announcement gains. It could have something to do with equities rallying in wake of Powell’s press conference, thus reducing the demand for safe-haven currencies like the buck. Again, analysts weren't sure why US equities would rally on a more hawkish Fed. It could be because equity market investors deem the Fed’s hawkish shift on Wednesday as appropriate and necessary. If so, gone are the days where equity investors crave a dovish Fed no matter what.

In the current environment of high inflation, perhaps equity investors are taking the view that its better for long-term earnings if the Fed lifts interest rates and brings back price stability than keeping interest rates lower. Either way, if this is the new mindset, that means equity market downside as a result of Fed hawkishness might be more limited going forward, meaning lesser demand for the safe-haven dollar. However, the dollar still stands to benefit from widening rate differentials versus its G10 peers, so it seems unlikely that Wednesday’s rally would be the start of a more sustained move higher. A retest of recent lows around 1.0800 seems more likely that a recovery back above 1.1200 at this point.