All of these changes may appear to be modest at best. Especially as “reaching the standard of substantial further progress is still a ways off”. However, as we have clearly demonstrated in many of our Long & Short opinions, the market consensus view has likely been predicated on the view that a persistently dovish Fed (one that remains intentionally behind the curve) enables markets to focus on the very near-term growth differentials (heavily distorted by reopening bounces and recovery lags) and even the marginal adjustments to quantitative easing (QE) programmes relative to the Fed.

Further, we have long maintained the view that ultimately markets should focus on the equilibrium or sustainable level of post covid growth (in this regard we see the US widening its positive growth differential, relative to other major economies) and that the USD can outperform in this positive scenario as illustrated by our Dollar Smile Framework (Constructed by Stephen Jen and Fatih Yilmaz in the early 2000’s).

We are clear to admit that it has taken longer than expected for the market to shift to the right hand side of the Dollar Smile Framework; but we expect the current (albeit modest) hawkish pivot of the Fed to facilitate a refocus of market expectations towards the "very healthy" US economic growth backdrop – and ultimately its widening positive differential – not on the technical or mechanical growth trajectory implied by economic reopening. We also think that the economic debate can shift away from which Central Bank may make a modest adjustment to their QE programmes and towards expectations of the terminal policy rate of the cycle – this likely has the biggest impact in terms of FX valuation implications and could lead to a EURUSD move back towards the end of the March 2021 lows.

In some respects, the renewed confidence that the Fed has shown in the US economy will need to continue to prove itself; and in that regard, the data, particularly around labour market activity and inflation, will remain a key focus. However, it is also important to put the hawkishness (relative to market expectations) of the Fed into perspective, given the huge amount of monetary and fiscal stimulus. With nominal GDP growth likely close to 10% this year we cannot be too surprised that the Fed is now suggesting that some stimulus may have to be removed over the course of the next 3 years!

This backdrop is likely to add to the complexities for emerging markets, particularly the higher beta, US rate sensitive currencies. Differentiation will likely continue to be a theme, especially in the context of our view that the focus of markets may start to shift towards sustainable growth and the likely terminal level of domestic interest rates. There is also likely an intensified impact from the flow of capital against this backdrop – that is a bigger debate.

For now, we are more comfortable in our view of USD outperformance and think that this week could be remembered as the week the Fed stopped not even thinking about thinking and started talking about talking. Normalisation is in train.