Important calendar events
The dollar continued gaining strength this week, with the dollar index climbing above 105.4 on Tuesday, ahead of Wednesday’s Fed monetary policy meeting. This marks its highest price yet this year and represents an impressive 20-year high. Bond yields also rose, with the US 10-year treasury note yielding firmly above 3.4% on Tuesday, a level that hadn’t been reached since 2011.
Continued Russian hostilities against Ukraine have increased risk-aversion sentiment, providing support for the dollar. As there is still no end in sight to the crisis, the dollar’s appeal as an investment remains high, although risk appetite seems to be gradually returning to markets.
High US inflation data boost the dollar, as high inflation rates increase the odds that the Fed will have to raise its interest rate to tackle inflation. PPI and Core PPI data on Tuesday, which are indicators of producer inflation, were mostly in line with expectations. PPI climbed 0.8% for the month and 10.8% on an annual basis, falling close to the historically high levels reached in March. Core PPI rose by 0.5%, which was higher than last month’s increase, but fell slightly below expectations. CPI in May increased by 8.6% on an annual basis, the largest year-on-year increase since 1981 according to the US Labour Department. Rising costs of food and energy have contributed to soaring inflation rates in the US.
The primary driver of the dollar remains the US Federal Reserve’s fiscal policy. In its last monetary policy meeting, the Fed raised its benchmark interest rate by 50 base points to 1%. FOMC members have pointed to a series of rate hikes of 50 base points each in the coming months, indicating that the Fed intends to move with a gradual but steady pace towards monetary policy normalization. Markets have already priced in a series of aggressive rate hikes this year, however, while Fed rhetoric remained more cautious recently.
This week, all eyes are going to be on the upcoming policy meeting on Wednesday. The Fed is expected to raise its benchmark interest rate in its monetary policy meeting on Wednesday, continuing its policy of monetary tightening and gradual return to pre-pandemic rates. A large number of Fed officials have pointed to a 50 base point rate hike in Wednesday’s meeting, which is a significant increase, although it has been considered conservative by several market analysts. Following the release of soaring US inflation data, however, many market participants are expecting that the Fed will move to a steeper rate hike of 75 base points. A strong probability of a 75 bps rate hike is being priced in by markets, boosting the dollar. If the Fed disappoints market expectations, the dollar may fall.
The Euro traded sideways against the dollar on Tuesday, even as the dollar rose to its highest level this year, with the EUR/USD rate fluctuating around the 1.042 level. The Euro started to regain some of its lost ground, as markets had time to absorb last week’s ECB interest rate decision. If the currency pair goes up, it may encounter resistance at 1.078. If the currency pair falls, it may encounter support at the 1.036 level which represents the 2016 low and further down near a 20-year low of 0.985.
Economic data released for the Eurozone on Tuesday were disappointing, with both ZEW Economic Sentiment and German ZEW Economic Sentiment decreasing and falling below expectations.
In the past few weeks, indications from the ECB that it would move towards a more hawkish policy bolstered the Euro, with markets pricing in up to 130 base points rate hikes throughout the year. The ECB kept its interest rate unchanged in its monetary policy meeting last week and issued a Monetary Policy Statement that was more dovish than expected, driving the Euro down. The ECB pointed to a small rate hike of 25 base points at its next meeting in July, which was more modest than expected, as markets were pricing in an interest rate increase of up to 50 base points.
The ECB has kept its interest rates below zero for over a decade and an increase in interest rates represents a hawkish turn in its monetary policy, to counter unprecedented inflation rates. The ECB has also signalled that it may gradually quicken the pace of monetary tightening, by raising its interest rate by 50 base points in September if inflation doesn’t improve.
Economic growth in the EU has been stalling after the pandemic, raising fears of a potential recession. Even though the ECB has pointed clearly to a shift towards a more hawkish policy, stagnating Eurozone economies limit the ECB’s flexibility to increase interest rates to combat high inflation. Inflation in the Eurozone climbed to record highs in May, reaching 8.1%, driven by rising food and energy costs. In addition, EU members recently announced a gradual ban on Russian oil imports. Concerns about rising energy costs in the EU that would bring inflation even higher up are putting pressure on the Euro.
This week only minor economic indicators are scheduled to be released for the Eurozone, which is not expected to generate high volatility for the currency. The Euro is more likely to be driven by the much-anticipated Fed and BOE meetings. The outcome of these meetings will likely have a strong impact on the Euro, especially if the two major Central Banks move towards a more hawkish policy than anticipated, further widening the gap, especially between their fiscal policies and those of the ECB.
German Buba President Nagel and ECB President Lagarde are due to deliver speeches on Wednesday, which may affect the Euro in the wake of the ECB’s latest policy meeting. Market participants will follow their speeches carefully for hints on the ECB’s fiscal policy in the coming months.
The sterling continued falling this week, pressured by disappointing economic data, while the dollar gained strength on hawkish Fed expectations. The GBP/USD rate fell below the 1.200 support level on Tuesday for the first time in over two years. If the GBP/USD rate goes up, it may encounter resistance near the 1.308 level, while if it declines, further support may be found near 1.140. The dollar has reached a 20-year high this week ahead of the FOMC meeting on Wednesday and the dollar’s rally puts pressure on competing assets, driving the sterling down.
Economic data released this week for the UK fell below expectations, putting more pressure on the currency. Monthly GDP fell to -0.3% on Monday, while Unemployment Rate rose to 3.8% on Tuesday. Last week, the UK PM Boris Johnson won the vote of no-confidence against him by a narrow margin and the bleak political climate is reducing investor confidence in the Sterling.
Headline inflation in the UK rose to a new 40-year high of 9% in April, while core inflation hit 6.2%. The cost of living in the UK has been increasing, driven primarily by the high cost of energy imports, putting pressure on UK households. Stagflation is a risk for the UK economy, as for many other countries, as economic stagnation coupled with rising inflation creates a toxic mix for the economy.
The sterling has been losing ground against the dollar due to the divergence in monetary policy between the Fed and the BOE. Although the BOE started the year with a strong hawkish policy, it has recently backed down and moderated its stance, weighted down by the still fragile British economy. In its latest monetary policy meeting, the Bank of England raised its benchmark interest rate by 25 base points, bringing its rate to a 13-year high of 1%.
This week, the primary focus of investors will be the BOE monetary policy meeting on Thursday. Coming just a day after the Fed’s policy meeting, the outcome of the BOE’s meeting and the ensuing Monetary Policy Statement, are expected to have a strong impact on the Sterling. Britain’s uncertain economic outlook may force the BOE to hold back from shifting to an aggressively hawkish monetary policy to tame soaring inflation rates. A 25-base point rate hike is widely expected in this week’s monetary policy meeting, which will help the BOE to strike a balance between battling inflation and supporting the sluggish economy. Markets are pricing in an interest rate increase of over 30 base points, with the odds in favour of a 25 bp rate hike but some traders expect a 50 bp rate hike. Although this will be the fifth consecutive rate hike for the BOE, something that hasn’t been done in 25 years, market participants may consider a 25 bp rise in interest rate a sign that the BOE is slowing down its pace, which may drive the Sterling down, especially if the Fed moves to a 50 bp rate hike.
The Yen continued to retreat against the dollar this week, with the USD/JPY pair testing the resistance at the 2002 high of 135.3 on Tuesday. If the USD/JPY declines, support might be found near the 130.5 level and further down at the 127 level.
The dollar’s strong rally is making the Yen less appealing to investors as the two currencies are competing as safe-haven assets. The Yen has been losing its status as a safe-haven currency, however, and has been retreating since the beginning of the year, while the dollar has been outperforming compared to competing assets.
On Tuesday, the BOJ expanded bond-buying, to bring the yield on the 10-year Japanese government bond back within the 0.25% cap, after it had spiked to 0.33%. The BOJ continues to buy an unlimited amount of Japanese treasury bonds, defending their current low yield. In contrast, the respective US 10-year bond is offered with a yield of over 3%, more than an order of magnitude higher than the Japanese bond. The large divergence in bond yields makes the low-yielding Yen less appealing to investors than the dollar, pushing its price further down.
The primary driver of the Yen over the past few months has been the BOJ’s fiscal policy, with the BOJ following an ultra-easy monetary policy to support the struggling economy. BOJ Governor Haruhiko Kuroda has stated that the Bank’s primary focus is to support the Japanese economy which is still struggling from the impact of the pandemic. The BOJ maintains an ultra-easy monetary policy, despite Japan’s CPI inflation index breaching the BOJ’s 2% target, reaching 2.1% for the first time in seven years. The BOJ and the Japanese government are in favour of a weak yen, as it makes Japanese exports more competitive and bond-buying cheaper. The combination of a weak currency and rising inflation, however, is burdening Japanese households.
This week, the BOJ Monetary Policy Meeting on the 17th is expected to have a strong impact on the Yen. Despite the rising inflation rates in Japan, the BOJ is expected to keep its interest rate the same, putting pressure on the Yen. Coming in the wake of the Fed and the BOE meetings, the BOJ meeting will likely emphasize the divergence between the BOJ’s fiscal policy and that of other major Central Banks, especially since both the Fed and the BOE are expected to raise their benchmark interest rates this week. While other countries are moving towards quantitative tightening to return to pre-pandemic fiscal policies, Japan continues to pour money into the economy and maintains its negative interest rate. The difference in interest rates with other major Central Banks, especially with the Fed, puts the Yen at a disadvantage, driving its price down.
Only minor economic indicators are scheduled to be released on Wednesday for Japan, which is not expected to affect the Yen considerably. The Yen will more likely be affected by the outcome of the US Fed monetary policy meeting on Wednesday.
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