Will USD continue its short-term rally?

USD is forecasted to continue its short-term rally within a longer-term downtrend.

 its short-term rally
There’s still a good chance of notable short-term dollar strength until the market can convince itself that the inflation threat has passed. 

Why is this? Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said the chances of a stronger dollar over the next few months are predicated on strong safe-haven dollar buying as the US’s inflation problem either forces the Fed to accelerate its monetary tightening or creates more global risk aversion because the Fed’s reticence sparks a sharp rise in bond yields. Either way, traders and investors are initially likely to flock to the dollar and, as we have seen on occasions in the past, these trends can produce quick and substantial strength in the dollar.

The rise is more likely to be concentrated against the riskier G10 currencies, with other ‘safe’ currencies like the yen and Swiss franc likely to rally alongside the greenback. The euro too may be able to stay closer to the dollar than many other currencies but, even here, the risk is a slide towards 1.05 for euro/dollar over the next few months.

But once we have got past any such flight to safety, what then? Will the dollar continue its climb, pushing on to parity and beyond against the euro for instance? Mr. Steve Barrow doubts it for two reasons.

The first is that we continue to regard rising global inflation as particularly problematic for the US. Already its rates of inflation have increased more than most others and that’s possibly a legacy of the fact that the Fed – and the White House – wants to run the economy too hot. Policymakers in the US overstimulated during the Covid crisis which has left demand outstripping supply by a margin that we don’t appear to be seeing elsewhere. In China and Japan, for instance, where policymakers have either resisted such pump-priming (China) or found it harder to boost demand (Japan) inflation is still very low. This is proving a double whammy for US competitiveness as the nominal exchange rate is rising at the same time as the US is inflating faster than most others.

The result is more pressure for the real exchange rate to appreciate and cost the US even more competitiveness at a time when the US trade and current account deficits are already ballooning. Of course, there is the argument that the US has no problem sucking the required capital into the country to fund these deficits. But the problem here is that this has helped inflate US assets, like stocks, and the dollar itself, to overvalued levels. “On this basis, we’d question the longer-term attractiveness of US assets over those in Europe, for instance, or emerging markets. If we are right about this the dollar should slide over the long haul, to our target of above 1.30 for the euro”, Mr. Steve Barrow said.

The second reason Mr. Steve Barrow would mention is that if things on the inflation front turn out very differently, with pressures receding quickly and the Fed able to proceed with monetary tightening at a leisurely pace, we are still likely to see the dollar fall over the long term because global investors will err towards riskier assets, including emerging markets, and away from the greenback.

“We would note that even in this scenario of more benign US inflation going forward, there’s still a good chance of notable short-term dollar strength until the market can convince itself that the inflation threat has passed. But we see this less likely of the two scenarios. Hence, we feel that the short-term strength in the dollar is more likely to be quite acute and, in turn, we are likely to see higher FX volatility continue. Remember we argued a short while ago that, very often when currency volatility gets down to the low levels we have seen recently, the next move is a significant spike higher. This might have already started to happen and, despite the recent rise, we think that FX strategies geared towards rising FX volatility are still the way to go”, Mr. Steve Barrow forecasted.