February’s Dollar gains are expected to be supported by the hawkish stance of the Federal Reserve, according to economists at ING. With few alternatives available, the Fed is backed into a corner and will have to announce its decision to sound hawkish. In addition, the recently revised Dot Plot fed funds expectation should further support this hawkish re-pricing of the Fed curve. A severely inverted US yield curve is not conducive to the kind of benign USD decline that seemed possible in January. These factors may make the Dollar stronger; however, central banks tightening into slowdowns will generate greater headwinds for risk assets. As a result, this is not a particularly positive story for pro-cyclical currencies such as the Euro, at least in the short-term.
In recent months, economic conditions across the world have been changing rapidly. However, the US economy has been performing better compared to most other economies. This puts the Federal Reserve in a strong position, making it the only central bank globally with any room for maneuvering. This has led to market participants pricing in additional rate hikes, which could help the USD hold on to its gains.
The European Central Bank and the Bank of Japan, on the other hand, are trying to find ways to stimulate their respective economies. This situation is making it tough for the Dollar to weaken; instead, there could be instances where the Dollar could strengthen. The Fed has been raising interest rates consistently, but it would be interesting to see what the Fed says at its upcoming policy meeting. The central bank may provide more guidance about its plans to raise interest rates further or give more insight into its stance on inflation.
In January, the Dollar was suffering from a weakness due to market sentiment bouncing back from the previous week. Additionally, the market was expecting the Fed to be dovish, and the tariff-related incidents between the US and China were reaching a dead-end. This dampened sentiment, which created an ideal environment for the Dollar to weaken.
However, this is not the case in February, and the trend may continue to impact the Dollar negatively. A more aggressive stance from the Fed may cause Dollar long positions to increase, which will, in turn, support the currency. Moreover, the Fed’s tightening cycle would cause the USD yield curve to realign, thereby providing more support for the currency.
Pro-cyclical currencies like the Euro may suffer from the Dollar’s potential gains, which may not bode well in the immediate future. These currencies have an inherent tendency always to rise when the outlook for the global economy is optimistic. The impending trade wars between the US and the rest of the world, however, may result in pessimism regarding the global economy. This situation could create additional headwinds for these currencies.
In conclusion, the Dollar is likely to hold on to its gains due to the hawkish stance of the Fed. The other central banks that are trying to stimulate their economies may continue to weaken their respective currencies, providing additional backing for the Dollar. However, the trade wars may create more headwinds for the pro-cyclical currencies like the Euro. This may continue to affect these currencies in the short-term; nonetheless, their long-term performance remains to be seen.
