USD: short term weakness, mid term strength?

Masive USD moves this week

Lorenzo Ippoliti, Milán

This week we witnessed some massive moves for the US dollar with the Dollar index closing at its lowest level in 8 months. The dollar lost 5.5% of its value against the Japanese Yen, the biggest weekly loss since 2008. Since the start of 2016 the dollar lost 11% against the Japanese Yen and more than 5.5% against the Euro.

The last leg of Dollar/Yen weakness started earlier this week as Japanese monetary authorities decided not to ease monetary conditions further while some market participants had expected a new stimulus from BoJ. This followed a relatively neutral FED meeting the day before in which the only slightly hawkish action was the removal from the final statement of the sentence referring to global risks for the economy.

At the beginning of the year there was consensus that the dollar would continue to appreciate.  This was based mainly on the back of divergent monetary policies as the US were starting their interest rate tightening cycle while the other major economies were still easing their monetary policy (remember that real interest rate differentials between countries tend drive the relative value of their currencies: when real interest rates rise in a country, foreign investors will be attracted by the higher returns obtainable and will increase the demand for the country’s currency lifting its value versus the other currencies).This positive dollar view was challenged at the beginning of the year when the selloff of risky assets around the world sent the dollar lower and then in March when the dovish stance of the Federal Reserve reduced the rates hikes expected this year from 4 to 2.

Gold prices also gained 5% this week lifted by dollar weakness and by the lowered expectations of a rate hike in the US. In fact, gold usually shows an inverse relationship with real interest rates (since gold does not pay any income, when rates increase the opportunity cost of holding gold increases).

Problems for the BCE and BOJ

Now the focus for the dollar shifts to the next 14 – 15th June Fed meeting. Fed Funds are pricing only a 12% chance of a rate hike in June and 44% of a hike by September. We feel that the market might be now underestimating the probabilities of a rate hike in June as we believe it is likely that the FED will want to adjust monetary policy before the Presidential Elections. The fact that the Fed removed its reference to global economic weakness from its statement may signal that it feels more comfortable with hiking rates.

We are also entering the pain zone for the ECB and the Bank of Japan. In fact, although the exchange rate is not a policy target for the two central banks, a significant appreciation of the EUR above 1.15 against the dollar and of the Yen below 105, would further derail the anti inflationary policies of Europe and Japan. So we would expect some verbal intervention by the ECB trying to push EUR down and some verbal and possibly market intervention (buying USD and selling Yen) by the BoJ.

USD: mid term strengh?

To conclude, technical and market positioning indicators are pointing to further short term dollar weakness, and we might see a further extension of current moves. We feel anyway that we are approaching levels where it could make sense to reinstate some medium term USD long positions as the market might be underestimating the chance of US hikes and BoJ and ECB might become more concerned about the strength of their currencies. Also don’t forget that renewed Brexit and Grexit fears might be on the horizon and this could increase the demand for dollars.

About Lorenzo Ippoliti.

Lorenzo Ippoliti is a proprietary trader with 20 years of experience mainly in Forex and credit markets. He has worked for some of the major banks in Italy. Lorenzo holds an MBA for the SDA Bocconi School of Management.

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