Having demonstrated a dizzying rise at the end of January, the US currency then experienced an equally rapid decline.
This raised questions, did the market adapt so quickly to the expectations of the Federal Reserve's aggressive fight against inflation, or was it a one-time event, and dollar bulls may return to the fight after a short break.
According to the results of last week, the greenback rose by 1.6% against its main competitors, and became the strongest currency of the Big Ten. In particular, the euro exchange rate decreased by 1.7% against the greenback.
The main driver of the dollar's strengthening was the results of the January Federal Reserve meeting, at which the central bank signaled that it plans to launch a policy tightening cycle as early as March, possibly with an increase in the key rate by half a percent at once.
Against this background, the USD index last Friday rose to the highest level in a year and a half at 97.44, and the EUR/USD pair sank to the lowest values since June 2020 in the area of 1.1120.
However, on Monday, January 31, the greenback fell sharply against all G10 currencies. The euro gained more than 1% against the dollar and was among the leaders of growth. Although, in general, defensive currencies were under pressure, even the yen and the franc were able to strengthen relative to the greenback.
What is the reason for the broad weakness of the USD?
There are a number of reasons.
Firstly, the pullback of the US currency was caused by the cash flows of the end of the month, due to which investors had to sell dollars.
Secondly, the growth of risk appetite observed in global stock markets has also played a role, since the greenback is traditionally regarded as a safe haven currency.
It is possible that at some point traders will start to think that there really is something behind the "belligerent" rhetoric of the Fed. So far, even the prospects of the central bank raising the key rate by half a percentage point have proved unable to shock investors.
The main Wall Street indices recorded a significant rise in the last hours of trading on Friday, thanks to which they managed to win back the previous fall and come out in plus at the end of the week, increasing by 1.7-3.1%.
On Monday, US stock indexes again showed impressive growth, adding 1.2-3.4%.
According to JPMorgan analysts, the upcoming Fed interest rate hike should not put an end to the bullish rally on Wall Street, and the recent sell-off should be seen as an opportunity to buy back stocks that have fallen in price.
According to the consensus forecast, the central bank may raise the key rate at least four times this year, as it seeks to suppress rising inflation, but JPMorgan expects up to five increases.
At the same time, the bank's strategists' confidence that stocks can grow even against the backdrop of an increase in the Fed's key rate is based on the fact that the American economy is still in growth mode, and corporate incomes also continue to grow.
Thirdly, investors, apparently, decided that the Fed is not the only hawk in the city and began to put in quotes a scenario according to which the ECB may surprise with tough notes this Thursday, since the general trend traced in the plans of leading central banks is to actively fight inflation in 2022.
Although European Central Bank President Christine Lagarde has repeatedly stressed that the conditions for raising rates in the eurozone in 2022 will not work out, the money market stubbornly puts at least one rate increase of 25 basis points in quotes, and doubts that the ECB head will refuse any hints about such a possibility at this week's meeting.
Thanks to these expectations, the EUR/USD pair was able to recoup most of the losses it suffered following the January FOMC meeting on Monday.
Another reason for the weakening of the dollar is that a report on the US labor market for January will be published on Friday, but in the context of Omicron, market participants do not expect a positive surprise from the employment figures.
The flattening of the yield curve of US Treasury bonds also forced the greenback to go on the defensive. In general, it is believed that a flat curve is a sign of an impending recession, and an inverted curve already signals a recession. So far, the yield curve in the United States is fine, it has a normal shape, but, nevertheless, it is becoming flatter.
This indicates that the market believes that the economy will not allow the Fed to raise the rate so high as to contain price pressure. And such a scenario is negative for the dollar.
The basic price index of Americans' spending on personal consumption (the Fed's favorite instrument for measuring inflation) in December reached 4.9% in annual terms, which has not been observed since the beginning of 1983.
Separate reports showed that labor costs in the United States have increased by 4% over the past 12 months, which was the strongest increase in 20 years of observations. Experts warn that increased wage costs can unleash a "salary-price" spiral, which will only strengthen inflation expectations.
At the January meeting, the US central bank clearly indicated that it intends to respond to the situation "without delay and unnecessary frills."
Judging by how quickly the key US stock indexes recovered after the initial drawdown, investors have not yet believed in the seriousness of the central bank's intentions. They made a choice in favor of risky assets, as a result of which the demand for a protective dollar decreased.
However, if the Fed moves from words to actions, it is guaranteed to bring down the markets, contributing to the USD rally. And it will not be surprising that the greenback will reach levels around 100 fairly quickly. Next, dollar bulls can target 104. Growth above 110 is possible once this mark is surpassed.
Capital Economics analysts believe that the market is still underestimating how high the US interest rate should be in order to curb inflation.
Futures for the federal funds rate suggest a peak in the region of 1.75-2.0%. This will be a very low level by historical standards and will most likely leave real rates in negative territory.
"We believe that the final rate in the United States, currently discounted in the money markets, is too low, both in absolute terms and in comparison with similar rates in other countries. This is the key reason why we believe that the dollar will eventually resume its growth," Capital Economics reported.
So far, investors are sticking to the scenario according to which solving problems in supply chains will stop stimulating inflation and the Fed will not need to implement an aggressive series of rate hikes to contain price pressure.
Following the results of yesterday's trading, key US stock indexes rose by an average of 0.7%, extending the series of increases to three consecutive trading days.
The dollar continued to decline across the entire spectrum of the market, surrendered most of the positions won last week, and finished around 96.30.
The EUR/USD pair maintained a bullish momentum on Tuesday and bounced even further from the 19-month low recorded on Friday at 1.1120.
On Wednesday, it continued its rally above the 1.1300 mark, moving away from the previously achieved one-and-a-half-year low by more than 200 points.
The protective dollar held in the background as stocks remained in the black, while long-term U.S. government bond yields consolidated at the bottom of their weekly range.
Today, the USD index updated weekly lows around 95.80, continuing to lose ground for the third consecutive day.
Surpassing the 96.00 level cleared the way for the bears to 95.42 (low from January 20) and 95.10 (100-day moving average).
The report published today by ADP reflected that in January the number of jobs in the US private sector decreased for the first time since December 2020 – by 301,000 against the projected growth of 207,000.
Weak figures only increased fears for the fate of Friday's nonfarm and sent the dollar even lower in all currency directions.
Meanwhile, the EUR/USD pair received support from the eurozone inflation indicators.
According to Eurostat data, in January the annual consumer price index in the currency bloc jumped to 5.1%, which was higher than the preliminary estimate of 4.4%. The value of the indicator has become the highest in the entire history of the introduction of calculations.
The rise of inflation in the eurozone to a new record high last month has exacerbated already strong doubts that price pressures are as harmless and temporary as the ECB still expects.
Last week, ECB chief economist Philip Lane said that the central bank will tighten monetary policy if inflation in the eurozone is kept above the target 2%, but at the moment such a scenario seems less likely.
"Since the consumer price index in the eurozone turned out to be high in January, some market participants now expect that the ECB will have to sound more hawkish tomorrow," Commerzbank strategists noted.
Before the Fed meeting last week, which generated a new wave of speculation that the ECB would have to follow the example of its American counterpart this year and increase the cost of borrowing, money markets expected a more moderate increase in the deposit rate – to -0.4% by the end of the year. Now they are putting in quotes the probability that the ECB will raise the deposit rate from at least -0.5% to -0.25% until December.
Rabobank does not expect surprises from the ECB at its February meeting, believing that Lagarde is likely to tell the same story as in December.
"We expect the ECB to stick to the rhetoric about the temporary nature of inflation," the bank's experts said.
"Inflation is likely to nip demand in the bud before wage growth gets enough room to accelerate dramatically. Therefore, we maintain our forecast that in 2022 we will see the cancellation of pandemic-specific incentive measures. At the same time, the ECB is unlikely to turn into a major inflationary hawk," they added.
ING analysts believe that the ECB may disappoint the optimistic expectations of the market, and the EUR/USD pair will decline to the support of 1.1200.
"We believe that patience will prevail over panic in the ECB statement on inflation, and given that the bar for a hawkish surprise is quite high after the release of favorable consumer inflation data this week, we expect the EUR/USD pair to give up some positions after the ECB meeting. We predict that it will retreat back to the support of 1.1200, and the recovery of the dollar will cause a breakdown of this mark," they said.
If the ECB does not adhere to the hawkish position on inflation, and the Fed maintains a "belligerent" attitude, the divergence in the rates of central banks should deter traders from aggressive bullish rates on the euro and restrain the further growth of the EUR/USD pair.
In this case, it is hardly worth waiting for an immediate reversal of capital flows, which recently led the main currency pair to multi-month lows, and the current decline in USD is nothing more than a correction.
Today, the EUR/USD pair received a new boost to growth and recovered above the Fibo level of 50% correction of the decline of 1.1480-1.1120, passing at 1.1300.
"Currently, the EUR/USD pair is testing the 50-day moving average at 1.1310, which, along with the round psychological level of 1.1300, represents a key mark. Further, the resistance is at the level of 1.1335 and around 1.1350. Below 1.1300, support is located at 1.1280, and further - at 1.1250 and 1.1235," Scotiabank strategists noted.