Above: Archive image of James Bullard. © Pound Sterling Live. Always courtesy of CNBC.
The U.S. dollar sits at the top of its peers as European and other global economies reopen after the Easter holiday, with analysts citing comments from a senior member of the Federal Reserve for the fresh outperformance.
The dollar hit new highs in 2022 after St. Louis Federal Reserve Chairman James Bullard said the central bank needed to move quickly to raise interest rates to around 3.5% this year with several half-point hikes and that it should not rule out rate increases of 75 basis points.
Bullard mentioned “I wouldn’t rule it out” when addressing the prospect of a rate hike of more than 50 basis points.
A 75 basis point hike would represent a dramatic sign of the Fed’s intention to rein in rising inflation, and it’s something markets hadn’t priced in until commentary introduced the ‘idea.
The last time the Fed hiked 75 basis points was in November 1994.
Bullard was speaking to the Council on Foreign Relations during his comments which only fueled expectations of a series of rapid interest rate hikes at the Fed in 2022.
“Bullard spoke yesterday afternoon in a very hawkish tone suggesting that the Fed must move quickly to raise interest rates to around 3.5% by the end of this year and that the Bank should not rule out a 75 basis point rate hike if needed, although that is not its base case. The comments added to demand for the US dollar, with the dollar index hitting new 23-month highs,” he said. said Thanim Islam, Dealer Manager at Equals Money.
Money markets are now showing that investors expect another 215 basis points of rate hikes to be delivered by the Fed by the end of the year.
It is important to note that the TOTAL amount of rate hikes expected from the Fed in the current hike cycle has increased recently, which is generally favorable for a currency:
Above: Fed hike expectations rise, image courtesy of Goldman Sachs.
The increase in the total amount of increases to 2.669% in the above, from 2.543% previously, is generally favorable for the US dollar.
The exchange rate between the pound and the dollar fell below 1.30, the rate between the euro and the dollar fell below 1.07 to test 1.0761 and the dollar index – a measure broader of the overall dollar performance – reached new post-Covid highs at 101.77. (Set your exchange rate alert here).
“USD is making gains above key technical levels – suggesting a breakout is underway here. The main contributor to this move is the Fed’s divergence from other central banks on policy,” said Bipan Rai, head of North American foreign exchange. Strategy at CIBC Capital Markets.
The yen is the biggest loser, with USD/JPY now on track for its 13th consecutive daily decline.
The Bank of Japan is not expected to raise rates in 2022, confirming that it holds the biggest divergence with the US Federal Reserve, and it is this divergence that is helping the dollar against the weakly yielding yen.
“The U.S. yield curve is also inverting and indeed there are risks to U.S. and global growth. This suggests that the USD should continue to have the upper hand,” says Paul Mackel, who leads equity research. currencies at HSBC.
Above: The Pound-Dollar exchange rate at daily intervals showing an entrenched downward trend.
Bullard’s warning that a 75 basis point rate hike cannot be ruled out shows how concerned the Fed is about inflation levels in the United States.
By raising rates, the Fed would help slow economic expansion and calm inflationary pressures.
But this economic slowdown means that down the road the Fed may have to cut rates again. As a result, yields on bonds with longer maturities pay less than bonds with shorter maturities.
This results in a flat or inverted yield curve (this is reflected in the first chart above) as opposed to one that rises steadily to reflect the gradual rise in yields as bond durations lengthen.
“Early tightening should lead to flat or inverted yield curves, which in our experience is positive for currencies,” says Chris Turner, Global Head of Markets and Regional Head of Research for the UK and Europe. Central and Eastern Europe at ING Bank.
“An extreme example, which some clients have asked us about, is the extreme inversion of the US yield curve in the early 1980s when new Federal Reserve Chairman Paul Volcker raised rates to 15% and sent the dollar into recession,” he added.
Above: The dollar index is at its highest level since March 2020.
Turner says the dollar soared during this time. “Inverted yield curves also discourage currency hedging of bond portfolio flows – that is, it is positive for a currency.”
Safe-haven demand is also boosting the dollar, with the war in Ukraine escalating as Russia launches a new offensive in the Donbas region.
The dollar has tended to benefit from its dual quality of offering higher yield (thanks to Fed rate hikes) and continued uncertainty in global markets.
A widely watched survey reveals that global growth optimism among some of the world’s biggest investors has fallen to an all-time high.
The Bank of America Global Fund Manager Survey for April found sentiment “is bearish as fear of a fast and furious Fed sends global growth optimism to an all-time low.”
Reporting their latest findings, Bank of America says they “remain in the ‘sell the rally’ camp because the January/February sell was “the appetizer and not the main course of the ’22’.
Investors now expect the Fed to raise interest rates seven times, up from four times in March, with the cycle ending in the first half of 2023.
83% of investors polled now think the Federal Reserve is about to make a policy mistake, meaning it will have to reverse some of the cycle’s upside relatively soon after the end.
The survey showed a 7 ppt decline month-over-month to 71% of net investors who expect a weaker economy over the next 12 months, the most growth expectations lowest ever recorded.
“The dollar should remain favored until we see geopolitical risk and downside growth risk easing in Europe and China,” said Anders Eklöf, chief strategist at Swedbank.