Bilal Hafeez, Research Analyst at Nomura, explains that as is often the case, markets move when it is least convenient and the dollar has tumbled since mid-December until now – a period when investors were more likely to be embroiled in family dramas and over-eating than to be trading FX markets.
“Dollar weakness has come despite the passing of US tax cuts, an associated upgrade to US growth expectations and a hawkish Fed. There are many medium-term factors that we think are weighing on the dollar, but in terms of short-term factors, two stand out:
- The dollar typically falls after a hike. Markets are all about expectations and it was likely the expectation of the December Fed hike that was helping the dollar. The actual hike, then, would naturally reset those expectations and would lead to a “buy the rumour, sell the fact” dynamic in the dollar. Indeed, the dollar has followed a pattern of trading relatively well into Fed hikes, but selling off after. This time appears to be no different.
- Rising US inflation expectations could be hurting the dollar. Wednesday’s ISM report showed the prices paid component bouncing back from an earlier dip. Oil prices are marching higher. Importantly, US inflation expectations as priced by US rates markets have consistently risen since early December. The 10yr breakeven from the TIPS market breached 2% in recent days – the first time since early 2017, and the 5y5y inflation swap inflation breakeven has gone above 2.35%. The dollar does not always move with inflation expectations (notably during the” Trumpflation” phase), but typically it does. Some of this co-movement could be the dollar influencing inflation expectations, but some could be inflation affecting the dollar (through PPP, real yields or “credibility”). Either way, inflation could be returning as a market factor.”
“Of course, the start of the year is a period when market liquidity is poor. Therefore, we need to be cautious in extrapolating too much from price action, but these two factors do warrant some attention.”
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