Dollar traders relax after crisis

It was a classic case of buying the rumor, selling the fact.

In February of this year, investors and analysts feared the US economy was starting to warm up, raising fears of a resumption of inflation and forcing the Federal Reserve to step up its political tightening. This, in turn, led to a surge in US government yields, which propelled the dollar to a year’s high against its peers a month later.

Fast forward to the end of the first half and inflation in the United States is at its fastest pace since the global financial crisis, but the dollar has weakened for two consecutive months after appreciating in the first quarter .

Much of the change is due to US central bankers rushing to reassure investors that they will maintain extremely accommodating conditions, appeasing the surge in Treasury yields and the dollar’s exchange rate.

As a result, analysts are fairly confident that Fed Chairman Jay Powell and his board will “review” the price hike at the central bank’s rate-setting meeting next week, keeping the dollar on its back. current weakening path.

“The combination of stable Fed expectations and a booming global economic recovery should lead to recent dollar weakness [to] keep going, ”said Zach Pandl, co-head of foreign exchange strategy at Goldman Sachs, in a research note. He expected the euro to benefit the most against the US dollar.

Still, some strategists can’t help but wonder whether they should stick to selling the fact, or whether it’s time to start buying the rumor – and the dollar – again. Despite inflation exceeding 5% year-on-year, 10-year Treasury bond yields fell to their lowest level in three months, in a counterintuitive reaction fueled by the anticipation that policymakers will avoid the heat of the year. buildings in the economy.

“Getting the US inflation right could be the most important market call for the rest of the year,” said Athanasios Vamvakidis, global head of foreign exchange strategy at Bank of America in London.

A move by the US central bank to keep its policy unchanged would allow the dollar to continue its weakening trajectory, but perhaps not as much as traders anticipated in early 2021. Vamvakidis notes that forex markets are quietly anticipating less dollar weakness than at the start of the year, with consensus now calling for the euro to trade around current levels of $ 1.21 by the end of December rather than $ 1.25.

“For now, high inflation in the United States and a still accommodating Fed are keeping US real rates very negative, which is supporting the euro. The question is how long this is sustainable if US inflation proves to be persistent, ”he said, adding that the bank expected the euro to end the year at 1.15 dollar.

There are signs that investors could become too relaxed. Options markets show little nervousness about the Fed meeting, and Mark McCormick, global head of foreign exchange strategy at TD Securities, said negative bets on the dollar have started to pile up sharply again these days. last few weeks.

This adds to the risk of a sharp pullback in the currency’s exchange rate if the Fed hints at cutting asset purchases on Wednesday or before analysts expect it.

“Don’t expect a lot more dollar weakness this summer,” McCormick said.

There are also offbeat signs that there is a risk that traders are betting too heavily on the Fed’s commitment to keep liquidity plentiful. Standard Chartered analysts noted that Treasury Secretary Janet Yellen, former Fed Chairman, mentioned potential benefits of an environment of higher interest rates twice in recent weeks.

John Davies, a U.S. rate strategist at Standard Chartered, said the Treasury chief was very likely to defend the Biden administration’s budget plans rather than criticize Fed policy, but it was highly unusual .

“It is always striking when the treasurer of a public or private entity argues for higher borrowing costs,” Davies said.

Investors now expect the U.S. central bank to start cutting back on asset purchases in the first quarter of next year, with an announcement potentially slated for September, when the Fed meets for its annual symposium in Jackson Hole. , according to Oliver Brennan, head of research at TS Lombard.

But while an earlier-than-expected announcement would cause a stir, the real risk is that investors will have to start anticipating the timing of U.S. rate hikes, which could come sooner and harder than they do. had planned.

“Taper runs clock for first rate hike and real rates rise [and] big changes in Fed policy seldom go smoothly, ”Brennan said.

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