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Edward Bell - Senior Director, Market Economics
Published Date: 24 May 2022
The US dollar has started this week on a soft footing after recording a weekly decline last week for the first time since the start of April. Some recovery in risk sentiment at the start of this week along with shifts in expectations from central bank peers of the Federal Reserve have helped to weigh on the dollar but we doubt that there will be a material push against the USD over the coming months. The balance of risks still appears to favour USD versus peer currencies before a modest appreciation by the end of this year.
Growing expectations that the ECB will start to hike rates as early as its July meeting have been a big part of the recent dollar weakness, helping to lift EURUSD in the last several days, taking it up from a recent bottom of 1.035 to around 1.06 at the moment. Christine Lagarde, president of the ECB, noted that July was likely for the ECB to start to lift rates but has pushed back against the idea that the bank would use 50bps hikes, like the Federal Reserve has done, in order to dampen down inflation. Some of the more outspoken hawkish ECB members, such as Klaas Knot, governor of the Netherlands central bank, have been openly pushing for large hikes to fight against eurozone inflation that was at record highs of 7.4% y/y in April. Markets are currently pricing more than 100bps of hikes from the ECB this year, taking the deposit facility rate from -0.5% to around 0.5%-0.6%, the first positive rates since 2021. While that would be a meaningful shift from the ECB, it would still leave rates well behind the Fed where we, and markets, expect rates to end 2022 at around 2.75%.
But it is not just to the single currency that the dollar has succumbed. Sterling has also recovered from the sharp sell-off spurred by the Bank of England disappointing markets earlier this month by hiking rates by just 25bps despite outlining a dire inflation outlook. GBPUSD has moved over the lows of 1.21 hit in the middle of May to push back well up above 1.25 at the start of this trading week. The near-term outlook for the UK looks negative, the strong bounce in April retail sales notwithstanding. Inflation in the UK was at 9% y/y in April which is 700bps above target levels and the Bank of England expects it to keep rising. Yet there is seemingly no conviction on the part of markets that the BoE will deliver enough rate hikes to tackle inflation, pricing in around 140bps of hikes by the end of this year that would take the Bank Rate up to 2.3%.
While the ECB and BoE are starting off at a slower pace than the Fed or may pause their hikes prematurely, they are at least moving in the direction of tighter monetary policy, rather than maintaining the pandemic-related accommodative stance. The Bank of Japan remains one of the few major monetary policy outliers in keeping policy loose in order to achieve sustainable inflation of 2%. Inflation in Japan has picked up, rising to 2.5% y/y in April, breaking above the BoJ’s target level for the first time since 2014 but we doubt that will push the BoJ to tighten policy prematurely. Governor Haruhiko Kuroda noted that Japan’s inflation dynamics are mainly caused by higher energy prices, rather than domestic drivers, and thus not entrenching higher prices in Japan’s economy.
In sum, the dollar has hit a wobble but the fundamental supports for a stronger dollar remain in place: a strong path of policy normalization from the Fed, via rate hikes and quantitative tightening, along with a haven bid amid broader financial market volatility. Currencies will start to show some life against the dollar by the end of the year but will still be soft in the context of the last few years.
Source: Bloomberg, Emirates NBD Research.
Fed to keep focus on inflation
ECB kicks off hiking cycle
Bank of Japan holds policy unchanged
Inflation moves higher in the UK