On Wednesday, the greenback broke a winning nine-day streak and fell by more than 0.5% against its main competitors, including the euro.
Touching the highest marks above 100.50 since May 2020, the USD index retreated and ended the session around 99.80 amid improving market sentiment and falling US Treasury bond yields.
The indicator for 10-year treasuries fell to 2.688% the day before from 2.724% recorded on Tuesday.
Meanwhile, the key Wall Street indexes ended trading higher on Wednesday, increasing by an average of 1-2%.
Market participants continued to play back the US inflation data published a day earlier.
Although these data are hardly positive, they have given rise to hopes that the rate of price growth is close to its peak, and in the coming months we will see a trend towards a weakening of inflation.
The core CPI, which excludes very volatile food and energy prices, remains high and rose 6.5% year-on-year last month. However, any sign of softer price pressure is enough to weaken the dollar. Moreover, the monthly core consumer price index rose by only 0.3%, which is a moderate pace.
If core inflation continues to slow down, the Federal Reserve may take its foot off the monetary brakes and tighten its policy less aggressively.
The greenback failed to attract demand against the background of a positive shift observed in risk sentiment, and was under broad selling pressure, which led to a decisive rebound of the EUR/USD pair in the afternoon on Wednesday.
Taking advantage of the pause in the current dollar rally, the main currency pair changed course and rose by 0.54% to 1.0885 at the end of the day on the eve of the next European Central Bank monetary policy meeting.
"The dollar has been on a fair rise for several weeks, and it seems that the ECB meeting on Thursday gave the market a convenient reason to take some profit on the growth of the USD," Western Union analysts said.
Although investors do not expect any changes in interest rates from the ECB at the current meeting, they expect an increase in the hawkish tone from ECB President Christine Lagarde, who may hint at an increase in interest rates later this year.
Money markets are putting into quotes the possibility that by December 2022 interest rates in the eurozone will rise by about 70 basis points.
The sooner Lagarde and her colleagues intend to raise interest rates, the stronger the euro's response will be. The announcement of the initial step in June will confirm the hawkish attitude of the ECB. A signal of one rate hike in September will indicate a neutral position, and, finally, a refusal to act before Christmas will sound like a dovish refrain.
However, even if the ECB raises rates, their increase will start from a lower base. The central bank's key rate is now 0%, and the deposit rate is -0.50%.
In addition, any rate hikes will still leave the cost of borrowing in the eurozone at a lower level than in the United States. This fact is likely to return to investors' radars to haunt the euro as soon as the dust settles after the ECB decision.
It is also worth remembering that no matter how hawkish other central banks are, the Fed is still number one. When it changes its position, it will change the dynamics of the dollar. But now is not the case.
The combination of unstable positioning in the US currency with softer than expected inflation indicators in the US justifies the USD sell-off, but it looks more like a correction than a change in the exchange rate. The dollar is disappointed, but still feels comfortable on its throne.
Europe is suffering because of the military conflict on its eastern flank, while the cost-of-living crisis in the UK is already causing doubts for the Bank of England. Canada may benefit from American demand, but its oil supplies are already at highs. Far from the military conflict in the eurozone, Australia is struggling with a decline in demand in China caused by COVID-19 outbreaks.
Meanwhile, the US economy is still in good shape and is showing enough signs of inflation that the Fed could stick to a very hawkish line and act in accordance with it, and thereby, of course, increase the value of the dollar.
Therefore, the current weakness of the USD can serve as an excellent opportunity to buy it, especially in the absence of any alternative options.
The greenback correction may not last long after the revaluation of expectations for the final level of the federal funds rate, according to ING analysts.
Traders continue to bet that the Fed will raise interest rates by half a point at both the May and June meetings, but in recent days they have abandoned bets on the third increase in the cost of borrowing by half a point this year.
The futures market expects to see the federal funds rate at the end of 2022 in the range of 2.25% to 2.5%, which corresponds to the rate that most FOMC members consider neutral.
"I think we want to reach above neutral by the end of the second half of this year and get closer to neutral as soon as possible," said Christopher Waller, a member of the Fed's Board of Governors.
He noted that although US inflation has largely peaked, the Fed still needs to tighten policy to reduce demand and ease pressure on prices.
Waller's remarks contrast with the comments of his colleague, St. Louis Fed President James Bullard, who supports raising rates to 3.5% by the end of the year. He recently stated that it is a fantasy to think that inflation can be defeated with more modest steps.
In order for the central bank to achieve the goal outlined by Bullard, it will be necessary to raise the rate by half a point at all six remaining Fed meetings this year.
"The markets are now probably embedding a fairly rapid decline in inflation in the United States in quotes. Supply chain bottlenecks still suggest that the decline is likely to be long and slow, and ultimately this will continue to support expectations that the Fed will bring rates to the 3.00% mark. In other words, we believe that the markets will gradually return (to prices) the hawkish expectations for rates that have been adjusted in the last few days," ING strategists said.
"The weakening of the dollar caused by the narrowing of rate differentials may not last long, and the prospect of a 50bp increase in the federal funds rate in May and June should also contribute to maintaining demand for the US currency in the coming weeks," they added.
The USD index continued its retreat from almost two-year peaks on Thursday. It is currently trading down more than 0.2%, around 99.70.
The single currency is holding its positions ahead of the ECB's monetary policy decision, leaving no hope of extending its recovery above 1.0900.
It is likely that the markets are assessing the hawkish sentiment on the part of the ECB at the upcoming meeting, but this tone will do little to keep up with the aggressiveness of the Fed's approach to inflation, Western Union analysts say.
"Even a hawkish ECB is unlikely to change the narrative that the Fed is raising rates at a much faster rate than its European counterpart," they said.
The EUR/USD pair rose above 1.0900 ahead of today's ECB meeting, however, the central bank's message to the markets may disappoint hawkish expectations, pulling the pair down to the level of 1.0800, according to ING.
"Our baseline scenario is that the ECB will not meet market expectations regarding the hawkish tone of statements, since uncertainty about the development and economic consequences of the conflict in Ukraine should prompt politicians to keep all options open. In practice, this means that along with the demonstrated openness to raising rates in 2022, we can see the repetition of the mantra about the sequence of actions and the preservation of the asset purchase schedule under the APP program," the bank's strategists noted.
"The ECB's lagging behind the hawkish market expectations may lead to a weakening of the euro, which remains in an unfavorable external environment due to uncertainty around the French elections and the Russian-Ukrainian conflict," they added.
The day before, the euro stopped only a few steps from the 2022 low, recorded in March in the area of 1.0805.
It is worth recalling that in 1999, at the dawn of the euro's emergence, the return of the EUR/USD pair to the area of 1.0800 caused the capitulation of bulls of the single currency. The EUR/USD sell-off was stopped only two years after the single currency lost a quarter of its value and only after ECB interventions.
According to ING analysts, in fact, tighter monetary policy, rather than currency interventions, is the only reliable tool available to the ECB to combat the euro's weakness. Let's see if they are ready to use it.
TD Securities analysts expect that the ECB will most likely announce that its APP program will end in May and prepare the markets for a June rate hike. At the same time, they believe that the euro will remain under pressure, and growth attempts will quickly fade away.
According to experts, any rebounds of the single currency are likely to be limited due to the Russian-Ukrainian conflict. At least until this problem is solved, the economic prospects of the eurozone will remain in doubt, and cash flows will play in favor of the dollar against the single currency.
Credit Suisse strategists still hold a bearish view of the euro and are waiting for a breakthrough of the EUR/USD key trend and price support at 1.0830-1.0806.
"We maintain our bearish position and are waiting for a net breakthrough of 1.0830-1.0806 in due time, which will expose the 2020 low at 1.0635 and probably the fall will continue. Only a rise above 1.1185 will mark the base and an important low," they said.