Last year the Fed pursued the most aggressive monetary policy in many years, but in December 2022, officials began laying the groundwork for reducing the pace of tightening to standard 25 bp hike. There are signs that the US expansion is losing momentum while risks of sharper inflation easing gradually build up which contribute to an increasingly dovish market bias regarding the Fed actions in 2023, including rate cuts.After raising fed funds rate by a total of 4.25% in 2022, which consisted of a series of 75bp and 50bp hikes, the Fed hinted in December that the tightening episode may be coming to an end. The market in response revised the peak Fed rate from 5% to 4.75%. While inflation is still well above its 2% target and unemployment near historic lows, evidence is accumulating at the Fed that policy transmission (i.e., effects of monetary tightening) is becoming more significant and therefore the risks of policy overshooting are rising. This can be seen primarily in the real estate market, where mortgage rates reacted quite quickly, limiting mortgage demand, and thereby putting pressure on prices:As a result, rental rates began to creep down, albeit with some delay. This delayed effect is expected to be fully felt by mid-2023, which creates risks of a faster than expected decline in the Core PCE index, the main inflation metric for the Fed. Against the backdrop of these fears, the "sensitivity" of market participants to a potential error in the Fed's policy has increased, and asset prices may be inclined to overreact even to slightly hawkish policy hints. An excessively dovish line, in turn, can also turn into trouble – the market may perceive this as an imminent transition to lower rates, which in turn may cause unwanted easing of credit conditions, which will only further spin the inflation flywheel.The economic data for the US, published on Friday, did not contain big surprises, Core PCE in December rose by 4.4% (in line with the forecast), consumer spending decreased in monthly terms slightly more than expected – by 0.2%. The dollar index continues to move in a narrowing triangle, trying to find a balance near the level of 102:It is clear that the US currency will likely pick direction after the Fed meeting, given that the sloping triangle in the bearish trend is a breakout figure, a bottom-up breakdown of the level of 101.50 is more likely to mean that the next market target is a round level of 100 points.The data shows that the EURUSD's six-hour reaction to last year's decisions by the Federal Open Market Committee (FOMC) caused a movement within +/- 0.7%. And the currency options market prices in a 90-pip range for the EURUSD pair over the period covering the Fed and ECB meetings next week.The decision of the Bank of Canada to stop the tightening cycle at the level of 4.50% made an interesting impression on the dollar market – the US currency was also sold based on the fact that global central banks tend to synchronize their policy, that is, as a signal that the Fed might be preparing to complete the tightening.This suggests that the FOMC meeting may be more interesting for EURUSD than the market currently expects. The base case assumes that EURUSD continues to trade around 1.08/1.09 ahead of the FOMC meeting. Any suggestion that the Fed has all but stopped the tightening could see the EURUSD move to 1.10. However, the signal from the Fed that the potential for a 50 bp rate change persists, will most likely send the EURUSD to the 1.07 level.More broadly, EURUSD is likely to continue rising this year – possibly to 1.15 in the second quarter – this will be a time when US inflation reports will likely contain more downside surprises and China’s “restart” will be a tailwind for cyclical currencies, including the Euro.
