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Fear and the Fed
The uncertainty of the Federal Reserve’s behavior, from dovish in 2021 to hawkish in early 2022 to “let’s see” more recently, has not inspired confidence in markets, judging by their performance last week. Chairman Powell announced an increase in rates at his May 4th press conference and noted that a recession in the US might be necessary to avoid the damaging effects of long-term inflation. But Powell also suggested a greater degree of flexibility in the Fed’s forward actions, implying that the Fed will not force the US into a recession if it proves unnecessary.
Thus, after months of hawkish arguments that suggested policymakers viewed the present expansion as immutable and invulnerable, Powell returned to a more pragmatic view that Fed policy is not set on an absolute, preset course. CIO’s view on where the economy is headed and the potency of the Fed’s tools differs somewhat from that of the Fed. Nevertheless, Powell has appropriately warned that only with low, stable inflation can the US enjoy a long and healthy economic expansion.
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Fed hawks glide on risk off winds
Just how strong can the US Dollar get? This is the question most market participants on both sides of the transactional flow are asking, as the USD takes out 20 year highs on the DXY just last week5. Albeit this move is led primarily by the heavier weighted constituents of the JPY and EUR within the index, a broad USD strength has been seen across the full board, ranging from G10 to emerging markets.
We review the underlying factors, and short term prospects of the USD below.
US Dollar (USD)
The recent drive in favour of the USD can be derived from a number of factors, however the foundation certainly appears to be the Federal Reserve’s unrelenting hawkish outlook for rates. Last weeks vote confirmed a 50bps hike, shadowing the Bank of England’s 25bps nudge, with confirmation of the quantitative tightening cycle landing as expected5.
With a marginally more attractive cash value, the USD is proving the go to asset for concerned investors getting stung in the recent equity markets volatility.
Citi analysts are acknowledging the USD performing as a balanced hedge for investors in the current shaky environment, highlighted by the Dow Jones worst day since 20202, additionally noting last weeks considerable institutional flows away from Emerging markets into the USD3. This can also serve a troubling circular effect, as the USD appreciation is exacerbated, and the already expensive Dollar denominated debt in Emerging Markets risks becoming an unmanageable liability.4
Following the recent significant appreciation of the USD, and fall off in equities, there is propensity however for some of the pressure to be released, with Citi analysts noting that a rebound in equities may be a catalyst for a short term reversion, combined with some profit taking5.
This week, CPI (inflation) data will guide markets on the short term prospects of the USD, as the Fed continues to pour monetary policy water over the inflation fire, we will get a good marked view on how effective the year to date has been.
Reviewing the outlook longer term, it was noted that Chairman Jerome Powell chose to address the American people at the beginning of the meeting last week, given the concern for The Fed’s credibility6. Followed by the Feds aim to “strive to avoid adding uncertainty”7. Markets continue to battle with whether to believe the voice heard or what the eyes see. The volatility in markets seems to highlight the conjecture of this dichotomy, with the chart below of the VIX (the stock market volatility barometer) showing elevated levels over the last month.
British Pound Sterling (GBP)
A struggling pound did not see much relief last week, even with a 25bps rate hike from the Bank of England on Thursday. The narrative around the tightening monetary policy seems to be the overbearing concern, with UK growth looking tentative, pinned by the BOE warning of a contracting economy by 20235.
Of course growth data will be a key focus for the UK going forward, with March GDP being released on Thursday. Citi see’s further scope for pricing out the GBP rate curve, particularly on further negative readings5.
Euro (EUR)
The EUR, having been the punchbag in the G3 throughout early April has began to show some level of resilience, with somewhat sideways trading vs the USD around the 1.05 region. A supportive European Central Bank towards positive rates8, underwrites this recent stability in the pair. Meanwhile, the struggling pound has favoured the EUR/GBP pair, with key levels breaching 0.85. Whilst the GBP continues to struggle the EUR is likely to benefit from this in the short term.