FX drivers: has the USD peaked?

With the recent focus on Russia-Ukraine tensions, it’s easy to lose sight of the underlying FX trends as they fade into the background.

High inflation, stagflation, expectations of slowing growth, flattening yield curves, rate hikes and higher volatility have all filled the pages, but the central theme is the enormous range of uncertainty about the future.

Let’s take a look at a few of the factors that could influence FX markets in either direction, starting with the…

US Dollar (USD)

Much of the USD strength we’ve seen over the past few months has been driven by Federal Reserve hawkishness. We’re now approaching a point where there are so many hikes priced in that it’s hard to envisage the Fed being more aggressive than markets are pricing, but you never know…!

Interest rate futures pricing implies that the Fed Funds rate will be at 1% between June (ZQM2022) and July (ZQN2022).

There is a sense that this stance is approaching peak hawkishness from the Fed now. Typically the dollar would be expected to sell off after the first rate hike as other countries/currencies play catch up and outperform on a relative basis. But this whole pandemic period has been so abnormal it pays to be especially cautious when looking to history as a guide.

Inflation is still running a long way above target, and a strong retail sales print this week hinted at the difficulty of stifling demand when consumers are still pumped up from stimulus, savings, strong wage growth and higher asset prices (wealth effect).
High demand = stickier high inflation.

How are the rest of the FX Majors placed against the dollar?

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Pound Sterling (GBPUSD)

The Bank of England was early out of the gates in the hiking cycle too. Similarly to the Fed it looks for now as if the market has found a level of comfort with their hiking expectations.

One thing that might concern the Bank of England is the recent flattening of the 2s/10s curve. The difference between the yields on the 2 year bond and the 10 year bond were basically 0 earlier this week. This has been accompanied by commentary around tightening into a slowdown, with the 2 year yield representing hiking expectations, and the 10 year yield representing economic growth expectations.

Still, GBP has proven resilient, and gained against the USD in recent weeks.

Now pushing up into resistance, the bulls will be keen to see this break. One major downside risk is the Bank of England changing stance and pushing back more forcefully against rates markets pricing hikes to 1.75% by the end of the year.

New Zealand Dollar (NZDUSD)

Another of the early breakaway hikers, The Reserve Bank of New Zealand meets next week, and is widely expected to hike rates by 0.25% to 1%. Traders will be keeping a close eye on commentary and the RBNZ forecasts surrounding the OCR (cash rate).

Previous forecasts saw a peak at 2.6% by the end of 2023, but there has been some speculation that this could shift higher, perhaps to as high as 3%. Inflation’s coming in above forecast and inflation expectations have also increased. There have been rumblings about a 0.5% hike to get ahead, which seems ambitious.

Further hawkishness could give the kiwi a final boost through the 0.67 resistance level

Canadian Dollar (USDCAD)

The Bank of Canada surprised markets by maintaining rates at 0.25% in the last meeting. Hikes are expected to kick on from March. OIS markets see the rate at 1.5% by September…

Deputy Governor Lane sounded hawkish this week too:

"Currently, with inflation well above our target, we are increasingly focused on countering the upside risks,"

"We will be nimble — and if necessary, forceful — in using our monetary policy tools to address whatever situation arises,"

A hawkish central bank plus tailwinds from oil prices could be a potent mix…

USDCAD is sketching out a range here between 1.28 & 1.2650. If CAD picks up some steam and takes out the range lows, CAD bulls (USDCAD bears), will be eyeing a move to the next clear support zone at 1.2560.

Euro (EURUSD)

The euro has seen some extra volatility of late with the ECB finally shifting from their ultra-dovish position and facing up to inflation.

Once again, rates markets are pricing in hikes, but the ECB is expected to move far more slowly than their peers. Current EONIA rates imply a 0.25% between September & October this year, with a move towards an actual positive interest rate of 0.5% by July 2023.

Although this still leaves them way behind peers such as the UK (expected to be at 2% by May 2023), the assumption that the ECB would be perma-doves forever more is now being challenged…

European yields have increased significantly which has led to speculation of asset managers re-weighting towards European assets, and the prospect of euro inflows.

The turnaround has been notable, although the 1.15 resistance zone looks pretty formidable.

Australian Dollar (AUD)

"The Board is prepared to be patient as it monitors how the various factors affecting inflation in Australia evolve,"

That’s from the most recent RBA minutes. And they have been extremely patient, mainly because the inflation down under isn’t running as hot as in other economies.

Governor Lowe has eyes on wage growth and maximum employment goals:

"Over the period ahead we have the opportunity to secure a lower rate of unemployment than was thought possible just a short while ago. Moving too early (on rates) could put this at risk."

He added that a rate hike in August was possible however. Rates markets are betting the RBA moves sooner, probably in July.

After buyers stepped in just below 0.70, the AUD hasn’t looked back. Now sitting just below the 0.72 zone, AUD bulls will be looking for a 0.73 handle next.

Japanese Yen (JPY)

If the Bank of Japan ever hikes rates it will be a monumental upset in global markets. OIS markets have offered a token gesture by pricing 0.07% of rate hikes by March 2023, but the BoJ is just built different to the rest.

The main things to watch out for with JPY is the overall risk sentiment and the US 10 year yield. Typically, the two are highly correlated. Any episode of risk aversion usually sees inflows to JPY and US treasuries, pulling yields down.

A move beyond 116.33 could see JPY bears targeting the 2016 highs around 118.63.

Not investment advice. Past performance does not guarantee or predict future performance.