USD: A sharp rebound for the US Dollar in February

The FX market had a quiet start to the week, with the Swedish krona and pound being the best performers yesterday. However, for the month as a whole, the US dollar has shown strength, staging a strong rebound after a significant sell-off between September and February. The dollar index (DXY) has reversed over a quarter of the losses sustained during that period and is currently trading at levels seen in December.

The main reason for the US dollar's rebound is the hawkish repricing of rate hike expectations by the Fed in response to stronger US activity and inflation data at the beginning of the year. The latest PCE deflator report has prompted the US rate market to fully price in 75bps of further hikes, with a higher probability (~62%) that the Fed could even revert back to delivering larger 50bps hikes at the next FOMC meeting on 22nd March. (see the video below where Nathan and I talk in depth)

Fed Governor Jefferson, speaking yesterday, stated that he believes the current inflation could be more persistent than previously thought, and he is not in favor of raising the inflation target. He believes doing so would introduce additional risk and call into question the Fed's commitment to its goals, leading people to suspect that the target could be changed opportunistically in the future. However, there is a growing risk that if the Fed continues to raise rates further in restrictive territory this year to bring inflation back down to their 2% target, it could trigger a deeper recession. Governor Jefferson did signal some optimism that core services inflation could ease given recent data suggesting that labor compensation has started to decelerate somewhat over the past year despite tight labor market conditions.

The US dollar has been supported this month by the sharp rise in US yields, although this has been partially offset by the hawkish repricing in rate markets outside of the US. The US 2-year government bond yield has increased sharply this month compared to the Euro-zone and the UK. The hawkish pricing of rate hike expectations outside of the US has prevented the US dollar from reversing an even larger amount of losses recorded between September and February.

The losses were also driven by building optimism over the outlook growth outside of the US, which has become less important in driving US dollar performance recently. The China re-opening trade has lost momentum over the past month, with the Hang Sang China Enterprises Equity index declining by almost 15% since late January. Despite this, it is still expected that China's economy will grow more strongly this year, helping to weaken the US dollar. However, this trend is not currently being observed.

EUR: Regional CPI figures in focus

Today’s & tomorrow inflation figures for January are expected to be the main highlight of the week in the Eurozone. The figures for France and Spain, in particular, are likely to attract the most attention as they could potentially move the market. It is worth remembering that inflation rebounded in both of these countries in January, which supported the recent hawkish narrative of the European Central Bank (ECB).

According to the consensus forecast, we can expect a stabilization in the EU-harmonised French inflation at 7.0% and a slowdown from 5.9% to 5.7% in Spain. However, if there is a material surprise on the downside, it could suggest a more widespread easing in price pressures across the Eurozone. In such a scenario, today's regional Consumer Price Index (CPI) figures may undermine hawkish expectations for ECB tightening.

At present, markets are pricing in around 130-140 basis points of tightening before reaching the peak. This could offer some floor to the Euro, and any re-strengthening of the US dollar could see high-beta commodity currencies more at risk than the Euro for the time being. Nonetheless, there are still risks of the Euro being tested in the near term, with the possibility of it reaching 1.0500.

In conclusion, today's inflation figures are crucial in determining the future direction of the ECB's monetary policy. The recent rebound in inflation figures in France and Spain could add further momentum to the ECB's hawkish narrative. However, if the figures disappoint, it could dampen market expectations for ECB tightening, which could result in further downside pressure on the Euro. Despite this, the Euro remains relatively resilient against the US dollar, with high-beta commodity currencies more vulnerable to any re-strengthening of the US dollar.

GBP: Impact of new Northern Ireland deal may be only short-lived

Since the beginning of the week, the British pound has emerged as one of the strongest performing currencies following the confirmation of a new deal between the UK and EU on Northern Ireland. Dubbed as the "Windsor Framework," this agreement aims to address some of the contentious issues related to the existing Northern Ireland protocol, which requires checks on trade between Northern Ireland and the rest of the UK. The new deal is expected to reduce the number of checks and promote greater ease of trade, which has been welcomed by the markets as a positive step in UK-EU trade relations.

While the direct impact on the UK economy may not be significant, the announcement of the new deal has been a key driver of the pound's recent strength. However, sustained support for the currency may be harder to come by in the absence of additional positive news. Instead, the central bank's policy stance is likely to remain the primary driver of the pound's trajectory going forward.

With PMI data releases on the calendar today, investors will be closely monitoring the remarks of several Bank of England (BoE) officials. Jon Cunliffe, Huw Pill, and Catherine Mann are scheduled to speak, and their comments will be closely scrutinized for any hints about the BoE's upcoming policy decisions. The market consensus is already pricing in a 25 basis point interest rate hike in March, but the focus is now shifting towards whether the central bank will need to continue tightening beyond March. Market sentiment is currently tilted towards the hawkish side, with many investors anticipating a total of 80 basis points of tightening before the policy peak.

At present, the broader central bank narrative and improving UK economic indicators are not providing much reason for investors to unwind their hawkish expectations. As such, the pound may continue to demonstrate resilience compared to other pro-cyclical currencies. However, with many uncertainties and challenges still looming, it remains to be seen how long this trend will last.