While the US stock market continues to go from side to side, due to high geopolitical risks and the approaching Federal Reserve meeting, during which they are expected to significantly increase the cost of borrowing, the greenback has reached levels not seen in the last two decades.
The USD index rose by 0.65% on Wednesday, reaching the highest values since March 2020, above 103.00, supported by a jump in the yield of 10-year US Treasury bonds by 4%.
The day before, the indicator rose to 2.817% from 2.773% recorded on Tuesday. The indicator has been staying near peak levels since 2018. This makes riskier assets less attractive to investors who sell government bonds expecting higher interest rates.
The US central bank raised its key rate by 25 basis points last month, which was the first increase in more than three years, as part of the fight against inflation, which in March in annual terms grew at the fastest pace in the last 40 years.
Consumer spending accounts for more than two-thirds of economic activity in the United States.
Even with the sharp rise in food and gasoline prices, there are no signs yet that consumers will retreat.
Significant wage growth amid tightening labor market conditions and at least $2 trillion in excess savings accumulated during the pandemic provide protection against inflation.
According to BofA Securities, low-income consumers, who tend to be disproportionately affected by inflation, showed greater resilience.
"The low-income consumer is likely to remain resilient at least until the end of this year. But the path for next year and beyond is less certain. If gasoline prices remain high for the foreseeable future, they will eventually affect consumers' purchasing power, despite strong balance sheets," BofA Securities said.
NatWest Markets analysts point to a steady underlying momentum in the economy, despite the potential pullback due to Omicron and further price increases due to the conflict in Ukraine.
Wells Fargo strategists hold a similar point of view. They believe that strong fundamentals and still favorable financial conditions should contribute to the continuation of the economic recovery.
"However, the risks are undoubtedly growing due to both the weakness of global economic growth and the tightening of financial conditions, and they need to be closely monitored," Wells Fargo said.
According to experts, the Fed's signals that it will quickly tighten monetary policy threaten to slow down economic growth.
Goldman Sachs recently estimated that the probability of a recession in the United States in the next two years is 35%.
Deutsche Bank is less optimistic about the prospects for the US economy and warned that the US will face a serious recession next year.
"The US central bank is likely to undertake the most aggressive tightening of monetary policy since the 1980s, which will push the national economy into a significant recession by the end of next year," Deutsche Bank analysts believe.
According to them, it will take a long time before inflation returns to the Fed's 2% target.
"We conservatively assume that to accomplish this task, it will be enough for the federal funds rate to be in the range of 5% to 6%. This is partly due to the fact that the process of tightening monetary policy will be supported by the reduction of the Fed's balance sheet," Deutsche Bank said.
Now everyone is trying to understand how quickly the FOMC wants to bring rates to a "neutral" level, which, according to Fed officials, does not stimulate or hinder economic growth.
However, the problem is that no one really knows exactly where this "neutral" level is, and high inflation makes it more difficult to determine than ever.
It is still unclear how many rounds of rate hikes the US central bank will need to tame inflation, and what is the probability that policy tightening in the United States will follow the scenario that the futures market is currently putting in quotes, expecting the peak of the federal funds rate at 3-3.5% in 2023.
These expectations push up the yield of treasuries and the USD exchange rate, reduce forecasts for economic growth and put pressure on stock prices.
"Over the past 18 months, we have had a perfect scenario: economic growth accelerated and bond yields fell – the perfect combination for risky assets. Now we have the complete opposite," PineBridge Investments specialists noted.Key US stock indexes have already declined significantly since the beginning of the year. So, the S&P 500 sank by 12% and may lose at least 4% by the end of this month.
Meanwhile, the greenback has risen by 7.3% since the beginning of the year, and has added 4.5% since the beginning of April.Yesterday's session on Wall Street turned out to be, to put it mildly, vague. US stock indexes found it difficult to choose a direction on Wednesday, but as a result they were able to recoup some of the losses incurred the day before. In particular, the S&P rose 0.2%.On Wednesday, investors continued to monitor corporate reporting.
"Financial statements of companies support the market to some extent, but we do not think that this is enough for growth," said strategists at Principal Global Investors. They believe that the stock market will continue to move either sideways or down.The greenback, in turn, showed that it copes perfectly even without the support of risk flight, which was replaced by attempts to recover on stock exchanges.
The USD index rose to five-year highs around 103.9 points on Thursday, and a further jump higher will lead to the fact that it will reach levels that have not been since the end of 2002.
The greenback is actively getting more expensive for the sixth consecutive session. Even weak US GDP data for the first quarter of 2022 could not contain its growth.
According to the first estimate, the indicator decreased by 1.4% in terms of the year.
Judging by the dynamics of the USD, market participants hope that the US economy has retained sufficient underlying strength to withstand headwinds in the form of a surge in inflation and an increase in interest rates.
"Economic growth in the United States slowed sharply in the first quarter. This was due to the fact that the Omicron wave hit consumer confidence and people's movements. And now we should expect better growth in the second quarter," ING analysts said.It should be noted that the US GDP data published today are retrospective and may not reflect the true picture of the economy.
Therefore, the Fed is unlikely to deviate from the path of tightening monetary policy. The number one goal for the central bank now is to ease inflationary pressure, and the strengthening of the US currency should help this.
The dollar's growth is favored not only by the prospect of an increase in interest rates in the United States, but also by expectations that America will outpace the rest of the world in economic growth.
"The greenback should remain bullish for some time, as expectations for economic growth in the eurozone and China have declined markedly, while the Fed remains resolutely hawkish," Westpac strategists said.
"The USD index is likely to test the area above 104 ahead of the FOMC meeting next week, and a breakthrough of this level will clear the way for testing the level of 107, which was last reached in 2002," they added.
The dollar's strength is also explained by the weakness of its main competitors – primarily the euro.
The EU is suffering more than the US from the Ukrainian conflict and the severance of economic ties with Russia, and large-scale quarantines related to COVID-19 in China, the main market for the bloc's exports, are adding fuel to the fire.
European Central Bank President Christine Lagarde said on Friday that Europe is more integrated into global value chains than the United States. According to her, the share of trade in the gross domestic product of the eurozone increased in 2019 to 54% compared to 31% twenty years ago, while in the US the growth was 3%, reaching 26%.
Lagarde also referred to a recent study showing that 46% of German companies receive a large amount of supplies from China. Almost half of them plan to reduce this dependence. The military actions in Ukraine now mean that it is necessary to refocus the search for suppliers with the lowest costs on geopolitical alliances.
"We must try to increase the security of trade in these unpredictable times. Even those industries that are not considered strategic are likely to expect the destruction of the global trade order and adjust production themselves," Lagarde said.
The West has already imposed many sanctions against Moscow because of the military operation in Ukraine. Despite the fact that the oil and gas industry of the Russian Federation seems to be an obvious target for restrictions, so far only the United States and Great Britain have introduced real restrictions. Both countries have announced that they will completely stop importing Russian oil.However, Kiev is putting the most pressure on the EU countries, prompting them to impose sanctions against Russian energy resources. Based on the public statements of various European officials, they are ready to do this, but at some later date.
In the event of a full embargo, the EU will need to urgently find somewhere 3 million barrels of oil per day. The region is already buying oil from the United States, but it will have to dramatically increase supplies, which is very difficult, given the absence of an oil pipeline across the Atlantic.
The "green" initiatives that have been gaining momentum in the EU in recent years have received another powerful impetus after the outbreak of the conflict in Ukraine. The goal is to reduce dependence on fossil fuels, in the market of which Russia is a major player.However, at first, according to experts, one inflation will simply be replaced by another, which will be caused by an increase in prices for copper, nickel, aluminum, lithium, graphite and other minerals. Since these minerals are widely used in production, it will not be possible to localize inflation.
The IMF believes that metal prices can remain at record levels for decades, while there will be a reorientation to "green" energy sources.
Earlier this month, a reputable organization downgraded its forecast for the growth of the eurozone economy this year from 3.9% to 2.8%.
"The main channel through which the military conflict in Ukraine and Western sanctions against Russia affect the eurozone economy is the rise in world energy prices and energy security in member countries, which leads to lower production and higher inflation," the IMF said.
Increased tensions in relations with Russia and the risks of ending dependence on Russian oil throughout the EU reduce the growth prospects of the eurozone and put pressure on the euro. The EUR/USD pair is set to test the 2017 low of 1.0340, Westpac believes."An increase in the costs of transforming the energy sector, a blow to confidence and the potential for further lowering regional growth forecasts towards recession caused the collapse of the EUR/USD pair to 2020 lows in the region of 1.0635-1.0640 and their breakdown. We see the potential for aggressive testing of the 2017 low at 1.0340 with intermediate significant levels at 1.0450 and 1.0415," the bank's analysts said.
"It is difficult to understand what data from the eurozone can stop the fall of the euro ahead of the FOMC meeting next week. The single currency will now need to recover above $1.0760 to ease downside risks," they added.
Against the background of the prospects for the destruction of the currency bloc's economy, as well as a decline in production in the region, investors prefer to transfer funds to where it is more reliable, that is, to the United States. And the main beneficiary of these cash flows is the greenback, which is strengthening to the detriment of the European counterpart.
On Thursday, the EUR/USD pair updated the lows of the beginning of 2017, sinking below 1.0500. The breakdown of this mark makes players think about the possible achievement of parity, including due to the divergence of monetary policy rates on both sides of the Atlantic.
Investors are preparing for a much more aggressive tightening by the Fed and are betting that the cost of borrowing in the United States will rise by 1% at the next two FOMC meetings.
At the same time, market participants expect that interest rates in the eurozone will most likely not rise to the level of the United States either this year or next.
"The strengthening of pessimism about the eurozone economy and the clearly unfavorable divergence of the ECB and Fed monetary policy rates exposes EUR/USD to the risk of testing the low of the beginning of 2017 at 1.0341 in the coming days or weeks," Scotiabank strategists believe.
"If Russia blocks energy flows, the EU industrial complex may have to significantly reduce production, plunging the eurozone into recession. This will pave the way for testing parity for EUR/USD, as capital outflow from the eurozone will increase due to the deterioration of economic prospects, which will force the ECB to postpone the rate hike," they noted.
Russia's decision to stop gas supplies to Bulgaria and Poland is the latest blow to the single currency. After this news, concerns about the energy crisis in the EU have noticeably intensified.
The Kremlin has shown that it is serious, and this is a wake-up call for the rest. Germany and other European countries may be next in line to impose gas restrictions.
"It looks like this is the first open act of an energy war. The question now is whether the restriction will extend to other major importers, which could quickly become a serious test of European resolve to support Ukraine in the face of rising energy prices and growing recession risks," RBC Capital Markets said.
"The embargo may lead the European economy into recession sooner than many thought, and as a result we see a sell-off of the euro, expecting it to weaken to at least $1.05 in the near future and possibly approach parity," Bluebay Asset Management analysts said.
The EUR/USD parity will not be violated if interruptions in energy supplies are prevented and the ECB policy is tightened, as Rabobank believes.
In addition to the ECB, a lifeline for the euro, according to Scotiabank analysts, will be a significant weakening of military risks in Ukraine, which will eliminate fears of a recession in the eurozone, and the associated broad improvement in risk sentiment will lead to a decline in the US dollar.
In addition, the settlement of the Russian-Ukrainian conflict and the resolution of supply chain problems may ease inflationary pressure, which will allow the Fed to be less aggressive.
So far, Fed officials have expressed readiness to quickly raise the target rate to 2.5% to contain the record for 40 years of inflation in the United States.
At the same time, the futures market for the rate lays down an even sharper increase, expecting that the central bank at the next meeting in June will raise the rate immediately by 75 bps, to 1.75%, then by 50 bps in July, to 2.25%.
Therefore, there are no changes in the bullish mood of the dollar, and the EUR/USD bears' eyes are still directed to the downside.
The nearest support for the pair is at 1.0460, followed by 1.0410 and 1.0370.
On the other hand, the initial resistance is located at 1.0560, and then at 1.0600 and 1.0650.