USD Hovers Near 20-Year High on Safe Haven Status, Fed’s Hawkish Rhetoric

The US dollar has had an incredible two-month period so far, with the USD Index, which tracks the greenback against six other currencies, hitting on Monday, May 9, the highest level in two decades. The USD is benefiting from its safe-haven status amid the economic worries caused by the Ukraine-Russia conflict, while the Federal Reserve is decided to put a cap on inflation by accelerating the pace of the interest rate hikes. The latest Nonfarm Payrolls report and inflation data are keeping the door open for a more aggressive stance from the Fed.

Back in March, the USD was struggling to find its way. The USD Index fluctuated inside a horizontal channel, finding strong resistance near 99.350 and support near 97.700. After the last bearish attempt at the end of March, the dollar started to rally, and it has never looked back since then. On Friday, May 13, it broke above 105.00 for the first time in 20 years.

Since bottoming out at the end of March, the USD index has gained over 7%. It’s surged over 2% since last week alone.

Investors Bet on Hawkish Fed

After the US CPI defied the Fed’s expectations that high inflation was only temporary, the central bank is now ready to become tougher. Back in March, the annual CPI surged to 8.5%, which was the highest in about 40 years, adding to growing concerns of hyperinflation.

In the first week of May, the Fed raised the rate by 0.50% to a range of 0.75% to 1%, based on a unanimous decision from the Federal Open Market Committee’s (FOMC) policymakers. That was the biggest hike in 22 years, and this might be only the beginning.

The central bank also said that starting with June, it would begin reducing the $9 trillion pile of assets accumulated during its efforts to address the economic crisis caused by the COVID-19 pandemic.

As a rule, when the Fed decides to increase the interest rate, the market interprets it as a bullish signal for the USD, as investors are interested in holding more fiat instead of spending it on riskier assets.  

After lifting the rate higher by 0.50%, the Fed gave clear signals that it wouldn’t stop here. On Thursday, May 12, Fed Chairman Jerome Powell, who was recently confirmed by the Senate for his second term, said that the central bank should have been more categorical in the past with respect to raising interest rates.

Powell said:

 “If you had perfect hindsight you’d go back, and it probably would have been better for us to have raised rates a little sooner. I’m not sure how much difference it would have made, but we have to make decisions in real time, based on what we know then, and we did the best we could.”

The Fed has been facing criticism that its delayed measures were not enough to contain high inflation, which is a major risk to the US and global economy. Now the central bank is admitting its mistake, and it has the difficult task to bring down inflation from the 8% annual rate without causing a recession.

Seth Carpenter, global chief economist at Morgan Stanley, said on Sunday:

We live in the most chaotic, hard-to-predict macroeconomic times in decades. The ingredients for a global recession are on the table. Though the US may avoid a recession, markets will have to confront the rising probability of one.”

Despite worries about an economic recession, the Fed has no choice. St. Louis Fed President James Bullard, who has been supporting a more hawkish approach, said on Wednesday that he was happy with a plan to raise rates by 50 basis points at each of the next two meetings. He told Yahoo Finance:

“We’ve got a plan in place, which is 50 basis points at the last [May 4] meeting and at future meetings as well. I think that is a good benchmark for now.”

The policymaker said he would like to see the rate move up to 3.5% by the end of 2022.

Payrolls, CPI Data Leaves Door Open for Aggressive Rate Hikes

Recent jobs market and inflation data is adding to expectations that the Fed would continue with its hawkish stance, which further supports the US dollar. On the first Friday of May, the Labor Department said that nonfarm payrolls had increased by 428,000 in April, while analysts expected growth by 391,000 jobs. The unemployment rate remained unchanged at 3.6%. Average hourly earnings rose 0.3% last month, after advancing 0.5% in March, pointing to cooling inflation in the job market, which is good news for the Fed.

Paul Ashworth, chief US economist at Capital Economics, commented on the data:

Overall, with labor market conditions still this strong — including very rapid wage growth — we doubt that the Fed is going to abandon its hawkish plans because of the current bout of weakness in equities.”

Elsewhere, latest inflation data showed a deceleration in April, but prices are still maintaining at a high level compared to the same period in 2021. On Wednesday, May 11, the Labor Department said that the CPI had increased by 0.3% over March, the smallest gain since August last year, after a 1.2% monthly spike in March. In annual terms, the CPI rose 8.3%, higher than the expected growth of 8.1% but below the March reading at 8.5%, which was the biggest annual gain in 40 years.

While the latest data may suggest inflation might have peaked in March, it’s unlikely that the Fed would give up its plans to tighten monetary policy.

Moreover, not everyone agrees with the cooling inflation narrative. Economists at Jefferies, one of the 20 or so primary dealers that trade directly with the New York Fed, concluded that April CPI data hadn’t shown clear evidence that inflation had really peaked. The economists paid attention to the report’s “core” services inflation, which suggests the wage-price spiral is raising. Thus, the Fed would consider a 75 basis point rate at its next few meetings, they say.

What’s Next for the USD?

The US dollar has corrected a bit following the CPI data released on Wednesday. Nevertheless, the rally may continue as the Fed is ready to further tighten the monetary policy. Meanwhile, the greenback is still benefiting from its safe-haven status, as investors dump the euro amid fears of an energy crisis in the European Union caused by the conflict between Russia and Ukraine.

EUR/USD broke below 1.04 for the first time since 2017, and more investors are now anticipating the parity between the two.

Lee Hardman, a currency analyst at MUFG, told Reuters on Friday:

“In the very short-term, it’s difficult to see what is going to turn around the euro/dollar bearish trend.”

He also admitted that the euro could decline to parity and even below it within weeks or even days. He added:

“Unless the Ukraine risks start to recede, it is going to be very difficult for the euro to move much higher.”

Meanwhile, the British pound has declined below 1.2200 versus the US dollar for the first time in two years. On Thursday, the UK’s Office for National Statistics (ONS) said that the British economy had grown at less than expected in the first three months of 2022, as the cost-of-living crisis worsened. GDP advanced only 0.8% in seasonally-adjusted terms compared to Q4 2021.

The uncertainty in Europe and spiking COVID-19 cases in China are driving demand for the USD due to its safe-haven status, and this may continue in the coming weeks. 

 

 

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