The DXY pulled back sharply on Monday, at one point dropping under 107.0 amid profit-taking.
Recent macro developments has seen Fed tightening bets modestly pared, dimming the bucks appeal.
Morgan Stanley thinks markets underestimate the Fed’s willingness to tackle what they expect to be sticky inflation in 2023.
Profit-taking Weighs on the Buck
The US Dollar slumped on Monday, with the Dollar Index (DXY) at one point falling below 107.0 from earlier session highs above 108.0. The DXY, a trade-weighted basket of major USD pairs, was last trading in the 107.40 area, down about 0.5% on the day and around 1.8% below the multi-decade highs it hit above 109.0 as recently as last Thursday.
US equities have given back earlier gains and are now trading in the red, indicative of a pullback in risk sentiment in the last few hours. However, profit-taking on overstretched USD-long positions appears to be preventing the buck from recovering back into the green on an intra-day basis.
Traders Pare Back on Fed Tightening Bets
Recent US macro developments have also somewhat dimmed the buck’s appeal. In the July University of Michigan survey released last Friday, 5-year consumer inflation expectations fell to one-year lows of 2.8% from above 3.0% in June. That will have eased fears at the US Federal Reserve that inflation expectations are becoming de-anchored, reducing the pressure they feel to hike interest rates quite so aggressively.
In fact, the Fed had cited an upside surprise in the UoM inflation expectations guage back in June as a key reason why it opted to accelerate the pace of its rate hikes to 75 bps at last month’s meeting from 50 bps at the May meeting. Speaking of Fed rate hikes; last Wednesday’s hotter-than-expected US Consumer Price Index numbers, which showed headline price pressures hitting a four-decade high above 9.0%, initially sparked fears that the Fed might implement an even larger 100 bps rate hike later this month.
However, Fed policymakers speaking later last week (Christopher Waller and James Bullard) both pushed back against this idea and said a 75 bps rate hike later this month was most likely. This, combined with Friday’s data, has seen markets pare back expectations for how aggressively the Fed is going to hike interest rates in the quarters ahead, supporting stock prices. According to the CME’s Fed Watch Tool, there is only around a 30% chance that the Fed hikes interest rates by 100 bps later this month, down from above 75% last Thursday.
This week, Fed policymakers are in blackout, meaning they are not allowed to comment publically on the economy or policy, ahead of the July meeting. Meanwhile, aside from some housing data which should show the sector feeling the strain from a slowing economy, high inflation and higher mortgage rates, the US economic calendar is pretty bare this week. Friday’s flash July PMI survey data will likely be the highlight of the week and will give a timely update on the health of the US economy.
Markets Underestimating Extent of Fed Tightening in 2023
Morgan Stanley argued in a note on Monday that markets appear to be underestimating the willingness of the US Federal Reserve to keep monetary policy tight in 2023. Fed funds futures are currently priced for the Fed to have lifted interest rates to just over 3.5% by the end of Q1 2023, before then dropping rates back to around 3.0% by Q4 2023.
But Morgan Stanley thinks that rate cuts in 2023 would only happen under two conditions. Firstly, if inflation quickly recedes to the Fed’s 2.0% target and, secondly, if the Fed decides to focus on supporting growth even when inflation remains above its target. Morgan Stanley views both scenarios as unlikely and argues that, given the experience of the last 50 years, Consumer Price Inflation is unlikely to fall back to 2.0% quickly next year.
Rather, Morgan Stanley said they think the fed is likely to hike interest rates to around 4.0% in 2023 above what markets are currently priced for. If Morgan Stanley’s thesis proves correct as inflation remains sticky at high levels for longer than thought later this year and Fed tightening bets subsequently are built up once again, that could provide long-term support for the US dollar.
Dollar Pullback Supports G10 Rivals
Despite ongoing worries that Russia is not going to restart gas flows once Nord Stream 1 pipeline maintenance is complete on Thursday, a move which would surely confirm a European recession, the oversold EUR/USD rallied about 0.6% on Monday. The pair was last changing hands just below 1.0150, up about 2.0% from earlier monthly lows under 1.0. However, that still leaves it lower by around 3.0% on the month. The euro has been battered in recent weeks by spiraling energy prices and growing expectations for a recession.
Euro traders are looking ahead to this week’s ECB meeting, with the central bank expected to kick off a tightening cycle with a 25 bps move, as well as unveil a new tool to prevent “unwarranted” so-called “fragmentation” of Eurozone bond yields that prevents its monetary transmission. In other words, the tool is designed to prevent the yields of highly indebted Eurozone nations like Italy from blowing out as the ECB tightens. Speaking of Italy, traders are also monitoring what is going to happen with the government there after PM Mario Draghi resigned following a governing coalition member pulling out.
Elsewhere, the impact of the US dollar pullback is also evident in GBP/USD and USD/JPY. The former was last trading about 0.8% higher on the day but failed an earlier attempt to break back above the 1.20 level and is back to trading just above 1.1950. Sterling traders are this week keeping an eye on the Conservative Leadership race that will see the party select a replacement for outgoing PM Boris Johnson.
But a barrage of UK data, including jobs and inflation, will likely be the more important driver. “We expect this week’s data flow to help markets fully price in a 50bp rate hike by the Bank of England (currently, 42bp is priced in), which could offer some moderate support to sterling,” said analysts at ING.
Elsewhere, USD/CAD fell back under 1.30 and was last down about 0.4%, with the loonie supported by higher oil prices despite the pullback into the red in US equities. Meanwhile, NZD/USD was unable to hold onto Asia Pacific sessions it made in wake of much hotter than forecast New Zealand inflation figures for Q2.
The Aussie was able to hold onto gains of about 0.3% on the day, though AUD/USD pulled back a fair amount from earlier session highs in the 0.6850 area to current level around 0.6810. The Aussie is on Monday benefitting from a rise in global energy and industrial metal prices.
This article was originally posted on FX Empire