Last week, the US dollar rose markedly against its main counterparts. In particular, the Euro fell by 1.7% against the greenback. In a matter of days, EUR/USD lost almost 200 points. The USD index, on the other hand, gained 1.6%.
The greenback rose to its highest level in a year and a half and posted its best week in seven months, thanks to demand for safe haven assets amid a sell-off in risky assets triggered by more hawkish than expected statements from US Central Bank Governor Jerome Powell at the end of January's FOMC meeting.
The Fed chairman announced an aggressive move to tighten monetary policy and plans to start reducing the size of assets on the balance sheet.
Although the Fed warns the market in advance of such an outcome, investors were still not prepared for such a turn of events as six months ago J. Powell said that a rate hike would only be appropriate in 2023 and that a balance sheet reduction was out of the question.
The head of the US central bank said that the FOMC officials had not made any decisions on the policy path this time. However, he made it clear that the Fed would be quite "nimble".
After Powell's strong statements, the monetary markets began to put a more than 90% probability of at least four federal funds rate hikes by the end of 2022 and a 67% probability of at least five.
The Fed chair's hawkish comments caused the dollar to rally and put pressure on global stock markets.
Barclays strategists reported that the dollar rose again, gaining support amid a combination of overvalued rates and much weaker risk sentiment.
In their view, the possibility of further dollar gains based on expectations of a rate hike is limited, as last week's changes mean that an aggressive normalization cycle is already embedded in valuations. However, weak and volatile stocks could push it up.
The S&P 500 Index is down more than 9% in 2022.
Some analysts believe it is time to buy, as many stocks have reached attractive levels after the decline. Others, however, warn that the current performance does not fully reflect the coming market turmoil.
Buying during the recession has paid off for many investors over the past 2 years, as abundant pandemic-era stimulus has boosted stocks to new record highs. However, as speculation grows about when the Fed will start cutting assets on its balance sheet, some analysts say that the era of quantitative tightening has already begun. Investors will therefore have to accept the new reality.
The S&P 500 index could drop by another 8% in the short term, Barclays forecasts.
Analysts believe that after significant losses since the beginning of 2022, the decline in the US equity market could continue, so it is too early for investors to buy stocks on the downside.
Assets have been heavily overvalued because of the injection of excess liquidity, Bridgewater experts say. They expect the Fed will not stop until the US stock market is down another 20%.
Experts believe that this is a tipping point and that things will be very different now. In their view, conditions are unlikely to remain the same as they have been for the past couple of decades.
Bridgewater analyst doesn't think the Fed wants the market to crash, just reset to a level where it's more reflective of cash flows in the "real economy" and no longer a channel for inflationary pressures to build. He expects policy makers will be watching closely to see if lower asset prices have any effect on job creation.
A market correction might even meet the Fed's objectives if it helps put people who retired early back to work.
In addition, if equity investments become unprofitable, investors would be ready to absorb all sovereign debt issued by the Fed should the yield on 10-year treasuries reach 3.5% or even 4% compared to the current 1.8%.
However, the market quickly digested Powell's hawkish statements.
In the final hours of trading on Friday the S&P 500 Index managed to gain and go on the upside for the week, rising by 1.3%.
Improved risk sentiment led to some profit taking on the safety dollar.
After reaching an 18-month peak around 97.44, the USD index then corrected slightly to end the past five days near 97.23.
Taking advantage of the greenback's loosening grip, EUR/USD was able to return to 1.1150 from a 19-month low around 1.1120.
At the beginning of the week, the dollar is consolidating its recent gains and trading 0.6% below the highest levels reached previously since June 2020, as weaker market volatility has reduced demand for safe haven assets. US stock futures are trading in the green zone today, adding around 1%.
However, there is still a chance that investors could see renewed volatility this week as central banks in Australia, the UK and Europe are due to meet in the coming days and the United States will release key employment data.
Strategists at Saxo Bank believe that a hike well above 2% for 10-year US bonds, combined with even higher expectations of hawkish Fed policy, could extend the dollar's strength for a longer period of time. If long-term treasury yields remain flat, it would be difficult to imagine that short-term policy expectations of the Fed would extend much further, since they have already priced in five interest rate hikes in the US this calendar year.
They added that the world has not come to a head with the Fed, and if the US Central Bank moves decisively to get ahead of inflation, they can expect even the ECB to do the same, especially as world prices are usually set in US dollars and price levels can rise even faster in other countries.
Sax Bank noted that there is a chance this week to see to what extent signals from other central banks can counter the strength of the dollar. The Bank of England is ready for a 25 basis point rate hike and the RBA will undoubtedly end quantitative easing. They expect the ECB to capitulate at some point, but it is probably too early for that and we should not expect much from the regulator.
Analysts at JPMorgan Chase believe that the US currency has not yet exhausted its upward potential.
They reported that the market was trying to decide on a fair USD price. The USD usually forms a top about 1-2 months after the Fed rate hike.
The bank said that this cycle is ordinary, with the market trying to keep up with the Fed. Initially it was thought that inflation would fall when supply chain issues were resolved, but it is now clear that it is not getting rid of so easily.
JPMorgan still prefers to buy the dollar against low-yielding currencies such as the euro and predicts that the EUR/USD pair will test at least 1,1000.
At the beginning of the week, the main currency pair is showing an increase. From its lowest levels since July 2020 on Friday, it has already bounced back by almost 90 pips.
However, any greater strengthening of the euro against the US dollar seems unlikely in view of the continuing divergence between the ECB and the Fed.
Although some consolidation may follow last week's sharp moves, the market is still inclined to rate interest rate hikes in the United States more, not less, with USD support and a bearish impact on EUR. It is possible that over the course of the year the market will return to less hawkish expectations on the Fed and reverse expectations on the ECB.
Rabobank strategists believe the greenback will keep its upside potential in the first half of 2022. However, they add that the euro could turn the tables in the second half of the year.
Rabobank maintains a six-month bullish outlook for the dollar and expects EUR/USD to fall to around 1,1000 by mid-year. The markets are currently pricing in five federal funds rate hikes of 25 basis points each over the course of one year. Perhaps these are too aggressive estimates. The bank is expecting four rate hikes from the Fed in 2022. It believes that if the market starts to revise its expectations regarding the pace of monetary policy tightening in the US, the USD could experience a pullback.
As for the near-term outlook, the main event for the euro this week will be the ECB meeting on Thursday. However, this event is unlikely to support the single currency and bullish momentum in EUR/USD is likely to be insignificant, ING specialists say.
On Friday, the United States will release its non-farm payrolls report for January.
The US economy is forecast to add 155,000 jobs, up from 199,000 in December.
Signs of continued strength in the US labour market could spur bets on how decisively the Fed could act to tighten its policy. This in turn would support the dollar and have a negative impact on the EUR/USD exchange rate.
Any rally in the major currency pair above the 2021 low around 1.1185 is expected to face resistance near 1.1220. A breakout of this level would allow the bulls to target 1.1250 on the way to 1.1300. Subsequent buying would be a signal that the pair has formed a short-term base and is ready to continue rising.
On the other hand, the nearest support is at 1.1150, and 1.1100. Failure to hold above these levels would leave the pair vulnerable to an accelerated fall to 1.1050 and then to 1.1000.