USD Outlook for 2022, Focus to Remain on Fed

The US dollar had a strong year in 2021, with the USD Index, which tracks the greenback against six other currencies, surging by about 7%. It was the best year for the American currency since 2015, as the US economy continued to improve while traders were dealing with a more hawkish Fed by the end of the year.  

While the US has enjoyed economic growth that often exceeded expectations, inflation seems to get out of control. The latest official data released by the Labor Department showed that the US consumer price index (CPI) had surged by 6.8% in November year-on-year, the fastest acceleration since 1982.

The high inflation is caused by the Federal Reserve’s ultra-easy monetary policy. Following the devastating effects of the pandemic on the US economy, the central bank slashed the interest rates to record lows and initiated unprecedented bond-buying operations, thus making money more available to businesses and individuals in an attempt to encourage investment and consumption. While the Fed’s measures helped revive the economy, the increase in the money supply led to higher prices – what we call inflation.

The Fed kept saying that high inflation was a temporary issue, but the central bank seems to be forced to start increasing the interest rate much earlier than expected. Many economists anticipate that the Fed’s Federal Open Market Committee (FOMC) will consider a rate hike as early as March. The Fed has already launched the tapering of its bond-buying programs, thus tightening the monetary supply.

The only major currency that could stand against the US dollar was the Canadian counterpart, as the Loonie was supported by surging oil prices while the Bank of Canada also turned hawkish earlier than other central banks in developed countries. Elsewhere, the British pound fell over 1%, while the euro tumbled by about 7.5% versus the American currency. The Japanese Yen fell by over 10%, becoming the worst-performing currency among majors. Here is the performance of other currencies versus the US dollar in 2021:

Besides a more hawkish Fed, the US dollar is also benefiting from its safe-haven status as the Omicron variant of the coronavirus causing COVID-19 is spreading faster than all previous strains, with most developed countries experiencing record levels in the number of daily cases.

All Eyes on Fed in 2022

The next major moves of the US dollar are in the hands of the Fed, which apparently is ready to raise the interest rates three times this year. In mid-December, 12 out of 18 FOMC members shared their expectations for three rate hikes in 2022. That is a big change from September’s forecast, in which half of the Fed members anticipated at least one rate increase this year. The central bank also reduced its GDP forecast and raised the inflation outlook for 2021, 2022, and 2023.

Here are the Fed’s updated rate hike projections for the upcoming years:

Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20211215.pdf

Elsewhere, the European Central Bank (ECB) seems to be ready to maintain the ultra-easy monetary policy for much longer to support the economy, especially given the new coronavirus variant. This contrast in monetary policy approach gives the greenback more weight, and the EUR/USD pair may continue the decline this year.

Analysts at Scotiabank said in a recent note to clients:

We see continued weakening in the shared currency next year to the 1.10 mark and likely beyond as headwinds remain firmly in place, where only the (highly unlikely) chance that the ECB hikes in late-2022/early-2023 possibly providing some support.”

At the time of writing on January 3, the EUR/USD pair is trading at 1.1296, and it started 2021 well above 1.20.

Analysts at Wells Fargo also expect the EUR/USD pair to touch the 1.10 mark this year. Nick Bennenbroek, International Economist at Wells Fargo, reportedly said:

As the Fed and foreign central banks become more active over the next several quarters, we believe monetary policy differences will become increasingly important for currency performance during that period.”

The ECB seems to pay less attention to inflation concerns compared to the Fed. Recently, ECB President Christine Lagarde said that the central bank anticipated that Eurozone inflation would eventually normalize and any kind of tightening could do more harm than good.

Meanwhile, the Fed funds futures are pricing in a greater than 50% chance that the central bank will increase the rate by 0.25% by March. Such odds were unheard of as recently as the beginning of December.

If the Fed happens to scale back its rate hike plans, the US dollar might weaken against the euro and other majors, so the three rate hike rhetoric should maintain throughout the first quarters of the year.

While the Fed was in the spotlight for the most part of 2021, investors might shift their focus to the ECB by debating over its next plans for 2023. Javier Corominas, director of macro strategy at Oxford Economics, said in December:

We expect the market to focus next year much more on the likely path of the ECB in 2023, much as this year the focus was on the Fed’s potential actions for 2022.”

To recap, the difference in the monetary policy approach from the Fed and the ECB will define the next major moves in the EUR/USD pair, as the American central bank is poised to tighten its policy due to inflation concerns while the ECB is ready to stay patient.

Elsewhere, the British pound is also expected to weaken versus the greenback because of the more hawkish Fed. The sterling fell only about 1% against the dollar last year.

Last year, the Bank of England (BoE) confused investors with its decisions. At the November meeting, the bank failed to raise the interest rate when most analysts anticipated one. Subsequently, the central bank raised the rate from 0.1% to 0.35% when the market actually expected it to hold. The surprising hawkish tone came amid inflation concerns, as the UK CPI rose to 5.1% in November y/y – the highest since 2011. Nevertheless, the BoE’s recent rate hike comes amid a downbeat economic outlook, which doesn’t help the pound at all. This might be a policy mistake with repercussions in 2022. GBP/USD is trading at 1.3477, but it may drop to 1.28 over the medium term, the lowest since November 2020.

The UK’s economy is not looking good in the medium term, as industrial and manufacturing production, GDP data, the jobs market data, as well as PMIs have all failed to impress investors and support the pound. Meanwhile, the sterling has been under pressure amid fresh Brexit concerns and the surging COVID cases to new record levels.

The aggregate value of positions against the pound rose to over $4 billion before Christmas, the highest level since October 2019.

Inflation to Remain Biggest Concern in 2022

While the Omicron variant is causing many troubles in most developed nations, investors still consider that inflation continues to be the main concern this year. A recent CNCB survey that involved chief investment officers, equity strategists, portfolio managers, and CNBC contributors found that more than half of respondents were worried about the high inflation. The next major concerns are the Fed increasing the rate at the wrong time and the effects of the pandemic.

https://www.cnbc.com/2021/12/29/investors-fear-inflation-most-in-2022-and-see-lower-stock-market-returns-cnbc-survey-shows.html 

Brad McMillan, chief investment officer at Commonwealth Financial Network, said:

There are serious headwinds to worry about. Inflation is at the highest level in decades. Supply chain problems seem to be insoluble. If these issues keep getting worse, they could derail the recovery.”

While most analysts anticipate a stronger US dollar in 2022, things can quickly change at any point due to the unpredictability of the pandemic, which may cause central banks to take markets by surprise. 

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