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Edward Bell - Senior Director, Market Economics
Published Date: 14 June 2022
After two weeks of decline in May, the US dollar has come back in a big way since the start of June as it appears that the death of the dollar rally seems to have been a rumour and a greatly exaggerated one at that. The broad DXY index, weighted heavily against the euro, has pushed back to around 105, its highest level since the end of 2002, and there are few signs to push back against the rally, at least in the immediate future.
The euro had managed to rally for a few weeks on signs that the European Central Bank is now committed to fighting inflation with tighter monetary policy, both by ending asset purchases and via higher rates. That helped to give EURUSD a boost up to around the 1.08 level, though still well below levels seen at the start of the year. Likewise, the perilous inflation outlook in the UK seemed to give the Bank of England no other option but to hike to help stem aggressive price growth, allowing GBPUSD a momentary reprieve above the 1.25 level. Even the Japanese yen, with a still enormously accommodative Bank of Japan, managed to strengthen during May, falling from around 130 at the start of the month to nearer to 127 by the end of May.
Currency markets had turned their eyes away from the US in the last few weeks and in any event, data from the US had been coming in good but not overly hot. The May jobs report showed an ideal picture for the Fed: strong job growth and moderate wage increases. That allowed for hope to build that the Fed wasn’t going to have to hike aggressively on a sustained basis to carry on its fight against inflation.
Only way is up for the Fed
But that hope has now been crushed by the May CPI print of 8.6% y/y. Prices in the US have yet to respond to the 75bps of hikes that the Fed has already implemented and are now pricing the potential of a 75bps hike at the June FOMC alone, along with almost 200bps of hikes by the end of Q3. While we are less aggressive in our own expectation for the Fed (see Fed faces an ugly inflation outlook), we do note that risks for US rates remain very much on the upside, with the potential to end the year at 3.5% in a particularly hawkish scenario.
The ECB by contrast has committed to hiking rates in July but only by 25bps. Even if the ECB took steps to hike by 50bps at its meetings after July, Eurozone policy rates would still end the year 175bps below the Fed funds rate under our own baseline assumptions of US policy rates at 3% by the end of this year. The story is similar in the UK where the BoE is likely to keep using 25bps hikes for the remainder of its meetings this year to avoid worsening an economy that’s already showing signs of contraction: GDP fell by 0.3% m/m in April, its second monthly decline and worse than the gain expected by the market.
Policy differentials in play
Monetary policy differentials will be the key variable in determining the course of currency markets this year and with the Fed so far ahead of its peers in tightening policy, and seemingly in market conviction that it will actually take the required steps, the case for a strong dollar still looks sound to us. In addition, rising rates are crippling equity markets and forcing a liquidation of risk positions across all assets. That is helping a flight to safety toward the dollar, enacting a somewhat self-fulfilling proposition of a stronger USD.
With the sell-off in currency markets looking disorderly we see no imminent restraint on the dollar, either from a macro or sentiment perspective. We had already been anticipating dollar strength against most currency peers this year and are now reinforcing that view. We now expect EURUSD to linger at around 1.05 in Q3 before a modest recovery to 1.07 by Q4 and then gentle gains in 2023. For GBPUSD the market has opened up new downside risk and we are targeting a level of 1.20 in Q3 and Q4 in light of deteriorating economic conditions. USDJPY has considerable topside risk, with tests above 140—USDJPY hit 144.46 during the 1997-98 Asia financial crisis—seeming likely.
Commodity currencies may weather the storm better given that central banks in Canada, Australia and New Zealand have already begun to use large hikes to normalize policy. But their high beta to risk assets generally will mean they will be subject to downside risks if sentiment continues to worsen.
Source: Emirates NBD Research, Bloomberg.
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