The USD rally is perhaps one of the highlights in the foreign exchange market this year. Over the past four months, the greenback has risen in price by more than 7%. In April alone, it gained about 4.5%. Why has the greenback strengthened so sharply? The main drivers of the dollar's growth were concerns about a possible collapse of the global economy, expectations of a sharp tightening of the Federal Reserve's monetary policy, as well as concern about the uncertainty associated with new geopolitical challenges. Money markets are currently pricing in the likelihood that the Fed will raise its key rate by 50 basis points at each of the next three meetings in order to curb inflation, which significantly exceeds its 2% target. Bets on the Fed's aggressive policy tightening course received an additional boost after the head of the central bank, Jerome Powell, practically confirmed that it would raise rates by 50 basis points in May. "A 50 basis point increase will be discussed at the May meeting," he said last week. The hawkish statements of Powell and other Fed members were prompted by talk about whether the central bank would hint that a much larger 75 basis point rate hike would be considered. "The final statement of the FOMC after the meeting and Powell's comments during the press conference will probably leave the door open for a 75bp rate hike, but we think it's too early for explicit approval," Nomura strategists said. The prospect of raising interest rates by 150 basis points in just three Fed meetings caused a new influx of funds into USD. Rising interest rates in the US usually favor the national currency, as higher rates attract investors. In addition, the dollar tends to strengthen when the global economy weakens, and when investors bet that the United States will outpace the rest of the world in terms of growth. "When such major central banks in the world as the ECB adhere to a soft monetary policy compared to the Fed, such a difference between interest rates largely determines the strength of the dollar," Nomura believes. Market participants are increasingly assessing the growing discrepancy opening up between the indicators of the eurozone and the US economies, and then the prospects for ECB and Fed policy, analysts at MUFG Bank say.
The euro lost almost 5% against the dollar in April and only about 7% against the greenback after the start of Russia's special military operation in Ukraine on February 24. The conflict between Kiev and Moscow, and especially the termination of Russian gas supplies to Poland and Bulgaria this week, has made investors worry about Europe's energy security, inflation and economic growth. Such concerns led to the fact that the single currency fell below $1.05 for the first time in five years on Thursday. Timid speculation about a rate hike in the eurozone in June-July was not enough to stop the weakening of the euro against the dollar. It is not surprising that the EUR/USD pair is trading at low levels. The euro exchange rate reflects market doubts about whether the European Central Bank will really raise interest rates in the near future, Commerzbank analysts say. "The termination of Russian gas supplies to Poland and Bulgaria has probably increased fears that the Russian Federation may stop gas supplies to other EU countries and, in extreme cases, to the entire bloc. If we saw a complete cessation of supplies, the issue of raising interest rates in the eurozone would probably be removed from the agenda. At the same time, inflation in the region is likely to remain at a high level," they said. "The high level of inflation, as well as the risk of weakening the economy, which may force the ECB not to take any action, put pressure on the euro. If there had been more confidence in the foreign exchange market that the ECB would fight high inflation, the euro would probably have won. However, while there is a risk of an energy crisis, the hawkish comments of ECB members will do little to overcome such doubts," Commerzbank added. According to Eurostat, annual inflation in the eurozone, according to preliminary estimates, accelerated in April to 7.5% from 7.4% a month earlier. The indicator became a record in the entire history of observations. "The bottom line is that high inflation cannot significantly help the euro until the ECB presents the time, place, roadmap and extent of monetary policy tightening to the markets," BMO Capital Markets reported. The ECB has so far been targeting markets for a rate hike some time after its bond-buying scheme, commonly known as quantitative easing, ends in the third quarter. But this wording is too vague, and the hawks in the ECB Governing Council insist on stopping bond purchases at the beginning of the third quarter and say that rates may rise in July. Part of the urgency lies in the fact that inflation expectations in the eurozone have begun to rise above the ECB's 2% target, which is a warning sign that investors and businesses are beginning to doubt the central bank's determination and ability to achieve its goal further.
The ECB is being cautious, since inflation has not reached its target for almost a decade, and the fight against excessive price increases is a relatively new phenomenon. The next ECB meeting will be held on June 9, at which policy makers are expected to set an exact end date for bond purchases and provide clear recommendations on interest rates. Money markets are pricing in an ECB rate hike by a total of 90 basis points by December. Meanwhile, the Fed may raise rates by at least 250 basis points before the end of the year. "In the eurozone, you are really only talking about getting this deposit rate out of negative territory and possibly back to slightly positive territory by the end of the year. This means that the European currency is depreciating," Royal London Asset Management analysts said. Raising rates in the eurozone is necessary to curb inflation, but at the same time the currency bloc is threatened by the energy crisis and the negative consequences of the slowdown in the Chinese economy caused by large-scale lockdowns associated with COVID-19. Such risks may force the ECB to continue to take a cautious position, as a result of which it will lag far behind the Fed. The Fed's willingness to act decisively to curb inflation should support the dollar, especially against the currencies of central banks such as the ECB, which continue to lag behind in tightening monetary policy, according to UBS analysts. The strengthening of the global economic growth problems is likely to maintain a higher demand for USD compared to almost all currencies during the second quarter, they note. "We still expect further growth of the dollar in the second quarter, and accordingly lowered our forecast for EUR/USD for June to 1.0500 from 1.1100 earlier. However, the arguments in favor of strengthening the greenback in the second half of the year are certainly not set in stone. Whether the US currency will strengthen further or there will be some kind of reversal depends largely on the consistent recovery of global economic growth in the 3rd quarter," UBS said. Recently, the differences between the hawks and the doves of the ECB have intensified. The former want to speed up the procedure of tightening monetary policy, while the latter note the current risks and point to the need for further stimulation of the economy. Meanwhile, FOMC officials have rallied around plans to raise the federal funds rate to at least 2.5% by the end of the year. However, they still disagree on where they should stop to avoid pushing the economy into recession. This debate is just beginning and will become more important in the summer as policy makers assess how quickly their initial rate hikes will slow household and firm spending and whether this, in turn, will slow inflation rates to levels not seen since the 1980s.
Much depends on how the underlying drivers of inflation will develop. In the absence of structural shifts, it is reasonable to perceive high inflation now as a temporary jump, and whatever the temptation of the central bank to suppress it by raising the rate, it is definitely not in the interests of the central bank to sacrifice economic growth. However, there is still ground for concern, since even before the pandemic, structural shifts in the inflation trend began to occur: this is both the rollback of globalization and demographic changes. In this case, the Fed needs to get serious about the tightening cycle. Many economists have recently raised their estimates of how much the Fed will need to do, and expect guidance from the central bank next week. "The labor market and wage growth associated with it remain high, and unemployment may fall below 3% this year. Consumers have so far been immune to Omicron, the conflict in Ukraine, a sharp rise in gas prices and a sharp increase in interest rates," Jefferies strategists said. According to them, for the US central bank, this could mean raising rates to more than 4%, a level that has not been seen since the financial crisis of 2007-2009, and which is likely to increase the risks of recession. "The American economy is climbing a wall of anxiety as inflation rises. However, the fundamental strength of the economy means that the Fed will have to be even more aggressive," Jefferies believes. A report published yesterday by the US Department of Commerce reflected that in the first quarter, national GDP declined by 1.4% year-on-year (if the indicator had grown at the same pace for four consecutive quarters). Analysts predicted the indicator to grow by 1.1%. "The US economy is still showing some resilience, but the GDP report for the first quarter signals the beginning of more moderate growth this year and next, mainly in response to higher interest rates. Despite the decline in GDP, the Fed has no choice but to aggressively raise rates in May to contain inflation," BMO Capital Markets analysts noted. "The Fed has done a lot of work to bring the markets to the state they are in now, and one surprisingly weak GDP indicator would never have allowed this to fall apart," MUFG Bank analysts said. A miss in the US GDP data for the first quarter cooled the rush of dollar bulls, which stopped only a few steps from the level of 104.00 on Thursday. Nevertheless, the USD index remained in positive territory, rising by 0.62% during the day. The greenback finished around 103.60, touching a 20-year high around 103.90 during the session. The pause in the rally of the US currency made it possible for the EUR/USD pair to stabilize. It ended yesterday's trading near 1.0500, after previously reaching the lowest level since January 2017 in the area of 1.0470. On Friday, the dollar continued to pull back from multi-year peaks in the direction of 103 after six days of continuous growth. The main question for investors is whether the greenback will continue to grow in May or not, CIBC analysts say. "We believe that the tightening of the Fed's policy is already more embedded in the USD exchange rate. This means that there is not necessarily an excuse to increase dollar reserves, which are already quite exaggerated," they said.
ANZ strategists hold a similar point of view. They believe that most of the Fed's hawkish attitude is close to being fully appreciated, which makes the further road of the greenback bumpy. "The cycle of a strong dollar looks protracted, as many rate hikes in the US have already been taken into account. We may not have reached the peak of the Fed's hawkish mood yet, but we are getting closer to it," they said. Meanwhile, ING analysts believe that there will be many who want to buy the US currency on the decline and are ready to take positions for the summer rally of the dollar, as the Fed presses the monetary brakes. Although fears persist that the Fed may aggressively tighten monetary policy and plunge the economy into recession, most experts are not convinced of this and point to strong domestic demand. The real growth rate of consumer spending in the United States, which accounts for more than two-thirds of economic activity in the country, increased by 2.7% year-on-year in the first quarter after an increase of 2.5% in the fourth quarter of last year. In addition, 1.7 million jobs were created in the first quarter, and manufacturing output grew by 5%. "There is no question of a recession yet. Underlying demand remains high, and the labor market is in excellent shape. We expect economic growth to resume in the second quarter," PNC Financial analysts said. Cash flows typical for the end of the month and profit-taking allowed the EUR/USD pair to break a six-day losing streak. It recovered somewhat on Friday, but faced strong resistance in the 1.0590 area. Players take profits, but are in no hurry to force events in anticipation of the next FOMC meeting. The Fed is expected to raise the interest rate immediately by 50 bps, to 1.0%, when it completes its two-day meeting next Wednesday. In addition, the central bank is likely to announce a reduction in the bond portfolio, which will begin in June and may accelerate in the future.
Some past cycles of Fed policy tightening have weakened the US currency as soon as they started. However, this time a comparison is being made with 1994, when a 300 basis point increase in rates raised the USD index by 4.6% (after a 10.5% jump in 1993). The fact that traders are not in a hurry to sell the US currency may indicate that there is potential for further strengthening of the dollar after a pause. In such a scenario, a steady growth of the single currency seems unlikely. Annual inflation in the eurozone accelerated in April to 7.5% from 7.4% a month earlier. Such a result will undoubtedly revive the hawks in the ECB Governing Council. Nevertheless, the money market has already included in the prices an increase in interest rates in the currency bloc this year by 87 bps, but this did not help the euro much, ING notes. "Of the many problems faced by the single currency, the most urgent is the abrupt shutdown of Russian gas in Europe. How this story will develop and the extent to which the eurozone economy will suffer (estimates vary in the range of 1-3%, subject to a complete cessation of supplies) will help determine the levels of EUR/USD," the bank's strategists said. In their opinion, the single currency remains vulnerable to a significant decline, up to parity with the dollar. "The currency options market puts a 35% probability in the prices that EUR/USD will reach the parity level before the end of this year. This is more than 25% at the beginning of this week and only 15% a couple of weeks ago," ING reported. The recent fall in the euro may be partly due to the closing of positions – weekly data from the Commodity Futures Trading Commission (CFTC) showed that hedge funds are generally neutral against the euro, and short positions on the EUR are far from the highs observed at the beginning of 2020. "Speculative positioning is much cleaner than before, which suggests opportunities for a larger accumulation of short positions in the euro," Citi analysts said. At the same time, the transition of EUR/USD to parity may face tough technical barriers in the form of the low of the beginning of 2017 at 1.0340, and then the level of 1.0200, which was last reached in December 2002. So far, the main currency pair is struggling to extend the rebound from the weakest levels in five years. Resistance above 1.0600 is located at 1.0660 (38.2% Fibonacci retracement level), and then at 1.0700 (50-day moving average).On the other hand, the initial support is at 1.0520, and then at 1.0500 (round level) and 1.0470 (multi-year low, recorded on Thursday).
