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The market looks minded to continue pricing de-escalation in the Middle East – notwithstanding some occasional surgical strikes from the US. Global equity markets continue to power ahead, although the dollar is staying quite well supported. That may be owed to the increasing view that the Fed will temporarily turn hawkish to ride out this inflation shock
USD: Fed Story Providing Support
With cash and futures equity markets powering ahead on Monday’s de-escalation trade, one might have expected to see the dollar weaker across the board – but it has been holding up quite well. We suspect this is being driven by the view that the Federal Reserve is about to turn less dovish at a time when softer activity data is raising questions over how aggressive other central banks, especially in Europe, can be with their tightening this year.
The Fed’s newfound position was nicely encapsulated in a speech by Christopher Waller last Friday entitled: ’Policy Risks Have Changed’. The market briefly priced one full 25bp Fed hike last Friday on his comments that the longer oil prices stay this high, the greater the risk of inflation expectations becoming unanchored and the Fed needing to hike. That briefly triggered some bearish flattening of the US yield curve – a clear dollar positive.
Looking ahead this week, the question is whether the dollar needs to sell off much if there is concrete news of de-escalation in the Middle East. We suspect the answer is ’not much’, with financial markets now more interested in the economic fallout on activity and inflation. For the US this week, the focus will be on whether the weekly ADP jobs numbers can stay strong (a cycle high at +42k was seen last week) and on the rate of inflation in April. Thursday sees the release of the PCE price data, where Waller estimates headline inflation will have risen to 3.8% year-on-year from 3.5% and core to 3.3% from 3.2%. Any upside surprises here would firm up the pricing of a Fed hike this year and help the dollar. There is a whole host of Fed speakers scheduled this week, too.
If the dollar remains steady to slightly stronger this week, it could give room for more local stories to shine through. Here, we think tomorrow’s Reserve Bank of New Zealand meeting could be a little more hawkish than expected, which could lend some support to the New Zealand dollar.
For the DXY, we expect it to remain supported in a 99.00-99.50 range, with Thursday’s PCE inflation data presenting the biggest risk of a range breakout.
EUR: Whatever Happened to Three ECB Rate Hikes?
Having priced over 80bp of tightening from the European Central Bank this year, markets are now pricing just 55bp. A lot of that adjustment looks like short-term interest rates slavishly following oil prices. Yet last week’s batch of softer European PMI data clearly warns of a contraction in European activity in the second quarter. The ECB is undoubtedly breathing a sigh of relief over market pricing of rate hikes, and we think it will hike only once this year, in June.
We have been saying for some time that we think EUR/USD fair value at the moment is around the 1.16/17 area and that there is not a strong case for a breakdown to 1.1500. Yet that may be the direction of travel should more members of the FOMC speculate about a rate hike, and as the European data continues to disappoint.
In terms of data this week, we’ll get our first look at some of the eurozone May inflation data at a country level and a final look at the first-quarter GDP readings. On the face of it, there is nothing clearly on the calendar to drive big market moves, and the offered tone in EUR/USD implied volatility looks set to continue. Expect ongoing interest to play the downside in cross rates like EUR/AUD, where the Australian dollar’s high carry and perhaps another hot Australian inflation release tomorrow (April data) could firm up expectations of even more Reserve Bank of Australia rate hikes this year.
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