Markets are in ‘wonderland’ when it comes to inflation and the Fed — and that’s sinking the U.S. dollar

- Advertisement -


The US dollar is offering a head scratcher in early 2022: Why the currency continues to fall as traders aggressively pencil in four interest rate hikes by the Federal Reserve this year as it tries to rein in red-hot inflation scrambles for?

- Advertisement -

ICE US Dollar Index DXY,
-0.13%,
A measure of the currency against a basket of six major rivals, fell 0.1% on Thursday to 94.81, a two-month low. The index is down 1% so far this week, making it down 1.2% since the start of the new year.

- Advertisement -

More aggressive tightening of monetary policy from a more “aggressive” central bank would typically be expected to support the currency. The reaction may make more sense, however, if one looks at how little interest rates are expected to rise eventually once the Fed begins the rate-hike cycle, said Kit Jux, global macro strategist at Société Générale.

He added that traders have seen prices sharply rise in four rate hikes this year, yet they look for the fed-funds rate, currently in the range of 0% to 0.25%, to no more than 2%. This is not realistic, but it can explain not only the recent performance of the dollar, but other assets as well.

- Advertisement -

“Markets are in wonderland,” he said in a Thursday note.

He said US stock market investors are happy with the prospect of a “terminal rate” of 2%, ignoring the more hawkish Fed as the prospect of a sharp rate hike reflects expectations that the worst of the COVID-19 pandemic is over. It is done, he said.

A fed-funds rate topping out at 2% is a “Goldilocks” scenario — at the extreme, Jux said, and it’s reflected in the 7% year-over-year increase in the December consumer-price index in Wednesday’s response, an approx. At a 40-year high, which saw the S&P 500 SPX,
-1.09%
climb back to its all-time high and within 2% of the Cboe Volatility Index VIX,
+7.32%
Hard to back down. The VIX, a measure of expected S&P 500 volatility, hit a four-week high above 23 earlier this week before sliding back below its long-term average around 19.

The dollar’s continued weakness is in line with the same overall sentiment, Jux said.

“CPI figures make headlines, but if rate markets don’t think they’re putting pressure on the Fed to tighten further (as opposed to sharply) and equity markets don’t think they’re a threat to the economy , then why should the FX market not conclude that other (cheaper) currencies may benefit as the post-pandemic recovery takes place around the world?” he asked.

The problem, Jux said, that a scenario in which the Fed can return the US economy to equilibrium with full employment and modest inflation by only taking rates to 2% is “the stuff of fairy tales, not the real world.” “

In fact, terminal rates below 2% are “according to a signal from policymakers to accelerate,” Jonas Golterman, senior market economist at Capital Economics, said in a Thursday note.

Fed Chairman Jerome Powell indicated earlier this week that policymakers want to move policy to a neutral or strict setting, suggesting a policy rate above 2.5%, Golterman said. And the suggestion that a “quantitative tightening,” as the Fed shrinks its balance sheet, will begin sooner and move faster than its previous tightening cycle, is another sign toward a higher terminal rate, he said.

“If the Fed succeeds in its clear intention to tighten the policy stance more broadly, we think this will strengthen the dollar,” Golterman wrote.

,

- Advertisement -

Stay on top - Get the daily news in your inbox

DMCA / Correction Notice

Recent Articles

Related Stories

Stay on top - Get the daily news in your inbox