FX rates projections based on central banks’ terminal rates

As we enter the second half of the trading month, the FX market participants prepare for an increase in volatility until the end of the trading year. 2020, central banks were racing to raise rates in the face of rising inflation.

All major central banks did so, except for the Bank of Japan.

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With a tightening cycle underway in most advanced economies, the big question on every investor’s mind is what the terminal rate would be.

By definition, the terminal rate is the level at which a central bank is not raising rates anymore. Knowing the terminal rate is important to FX traders because the FX market is all about interpreting interest rate movements.

Hence, the projected terminal rate tells traders what to expect in the upcoming months in order to position accordingly.

FX rates projections for the months ahead

The four major central banks tightening their monetary policy are the Federal Reserve (Fed), the Bank of England (BOE), the European Central Bank (ECB), and the Swiss National Bank (SNB). The forecasts are that the first three central banks will reach their terminal rates in December 2022, while the SNB only in March.

As such, the Fed is seen hiking up to a terminal rate of 4%, the Bank of England up to 3.25%, the ECB up to 2%, and the SNB to 1.25%.

The higher the interest rate, the better for the currency. Hence, based on these projections, the US dollar’s strength should remain the dominant theme in the FX market.

However, the gap between the Fed funds rate and the other central banks’ rates narrows. For example, by raising to 2%, the ECB narrows the gap with the Fed considerably, given that the deposit facility rate was -0.5% at the start of the summer months.

Having said that, EUR/USD should find buyers on every dip. Also, the EUR/GBP exchange rate will likely move sideways with a slight bearish bias as the BOE’s terminal rate is above the ECB’s.