US Dollar Fundamental Forecast: Neutral
- US Dollar DXY index hit a fresh 2022 record after the Euro sank on tensions in Ukraine
- Greenback strength persisted after Fed Chair Powell tempered bets on a 50 bps hike
- A lull in hostilities from Russia may see haven flows reverse course and drag USD
The US Dollar rocketed upward last week, hitting the highest levels since May 2020, as the situation in Ukraine deteriorated. That firmed up the chances that the West will lobby additional sanctions on Russia, increasing the already severe supply shock roiling markets. Russia’s assault on Ukraine has had an outsized impact on the Euro, mostly due to Europe’s high volume of trade with Russia. EUR/USD shed nearly 3% last week, dropping to its lowest level since May 2020. That provides an outsized advantage for the US Dollar DXY index, which is heavily weighted against the Euro.
A surge in commodity prices has been one of the most prominent spillover effects of Western sanctions. That has bolstered already lofty inflation expectations across major economies. Germany’s 2-year breakeven rate – the gap between the 2Y Bund yield and its inflation-indexed counterpart – rose to a record high of 4.24% on Friday. European gas prices extended higher into record territory on Friday. Europe is particularly sensitive to further escalations due to its geographical proximity and trade with Russia. The Euro is likely to remain bogged down until the tides turn toward a diplomatic solution, which should underpin USD strength in the interim.
Elsewhere, A strong US jobs report on Friday failed to reignite bets for a 50 basis point (bps) hike at the March FOMC meeting. Federal Reserve Chair, Jerome Powell, earlier in the week, said, “I’m inclined to propose and support a 25 basis point rate hike.” Mr. Powell reiterated the central bank’s view that inflation would begin to come down after peaking soon but also acknowledged the current upside risks to inflation. The Fed’s goal is to stabilize prices without inducing a recession, commonly referred to as a “soft landing.”
Nevertheless, the US bond market doesn’t appear that optimistic. US breakevens rose rapidly, with the 1- and 2-year rates eclipsing 5% and 4%, respectively. Those are well above the Fed’s target. The February consumer price index (CPI), on Thursday, is expected to hit 7.9% y/y, up from 7.5% y/y in January. That would be the highest number since January 1982. Meanwhile, the yield spread between the 2- and 10-year Treasuries has accelerated toward inversion, a closely-watched recession indicator. The measure dropped below 25 basis points on Friday. Yet, despite a pullback in rate hike expectations and growing fears over economic stagnation, the US Dollar finished the week at a fresh yearly high.
A currency would typically benefit from its issuing central bank raising rates at a faster-than-expected pace by attracting foreign investors seeking yield, but as discussed, rate hike expectations have weakened, and the USD continued higher. The DXY index is also coming off strong gains in the second half of 2021 at a time of relatively subdued market volatility, suggesting higher rates have largely been priced in.
Altogether, this points to a likely US Dollar pullback once tensions in eastern Europe subside, likely driven largely by a rebound in the Euro and global haven flows reversing back into riskier assets. Dollar liquidity may also improve. Banks started to hoard cash, reducing USD liquidity, as Russian banks cut off from the SWIFT messaging system and sanctions freezing Russian assets spurred a rush for cash.
The FRA-OIS spread, shown in the chart below, is the spread between the inter-bank lending rate and the fed funds rate, used as a proxy gauge for money market stress. The measure rose to its highest level since April 2020 on Friday. All things considered, the US Dollar looks prone for a pullback, but the timing is dependent on a complex geopolitical situation, making it a risky play.
— Written by Thomas Westwater, Analyst for DailyFX.com
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