After a long period of range bound trading, the DXY has finally broken out. For much of the year we saw the DXY index (an index which tracks the strength of the dollar against a basket of major currencies) trade between 89 and 94. In an earlier edition of this publication we indicated that a break above 95 could indicate a renewed dollar bull market move. Very recently we saw an aggressive break out with the DXY reaching 96.8, levels seen previously in July 2020. Although this move is significant, we are skeptical as to call a renewed dollar bull market just yet.
The appreciation in the dollar has been largely a result of rising US inflation and the perceived potential response of the Federal Reserve. The premise being that if inflation does not prove to be merely transitory (which is what the Federal Reserve has reiterated), the Federal Reserve would need to tighten monetary policy (raise interest rates) more aggressively than previously planned. US CPI inflation surprised to the upside and accelerated from 5.4% to a nearly 31-year high of 6.2% y/y in October. The market is now pricing in that the Federal Reserve will raise interest rates faster compared to what was priced earlier this year. The Overnight Index Swap (OIS) curve is now indicating two rate hikes by December 2022. See Figure 1. This US economic data which has been strong has further supported the dollar. Within the G10, the Citigroup economic surprise index (which measures the degree to which the economic data is either beating or missing forecasts) is much higher in the US (+19), than say, the euro area (-50) or Japan (-74). Another important release this past month was the US was the jobs report. Nonfarm payrolls increased by 531,000 jobs and unemployment fell to 4.6% in October.
Figure 1
During their November Federal Open Market Committee meeting the Federal Reserve announced plans to taper their asset purchases by $15 billion per month, with tapering expected to be completed midway through 2022. From a relative standpoint, the Fed is lagging many other major developed market central banks in normalizing monetary policy.
See Figure 2.
Figure 2
Many developed and emerging market central banks have already begun tightening monetary policy in response to higher inflation. If the US continues to lag other economies in terms of raising interest rates, interest rate differentials will be stacked against the dollar and which will lead to an outflow out of the US and a weaker dollar as a result. See Figure 3.
Figure 3
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