Although the dollar index fell to the lowest level in two years, it has room to recover.
JPMorgan believes that the US dollar can continue its upward journey even after the Federal Reserve starts raising interest rates. The Fed has been struggling with taming the fastest inflation since the 1980s. The dollar index has risen about 5% in the past year, raising questions about whether the uptrend is over.
However, in our view, the USD has more room to rise and make bigger gains. The markets are still in a mode of price discovery, and pricing economic data and Fed decisions. Notice that the dollar’s peak usually comes a month or two after the Fed hike rates.
Market expectations of five rate hikes this year have strengthened, following hawkish comments from President Jerome Powell during the last meeting. The US central bank may choose to start raising rates by 50 basis points at the March meeting.
The market is chasing the Fed, trying to anticipate its next moves, because this is clearly a very unconventional cycle. For example, the Fed initially predicted that inflation would calm down if the supply chain problems related to the pandemic subside. However, it recently acknowledged that this process is taking longer than expected.
Obstacles for the US dollar
The dollar may face obstacles that will hamper the upward trend, with a significant shift in tone from the European Central Bank and the Bank of England.
The Bank of England and the European Central Bank both met market expectations. The BoE raised the interest rate by 25 basis points to 0.50% for the second time in a row. At the same time, the ECB kept its policy unchanged but shifted its tone in addressing the risks of inflation attacking the Eurozone.
The dollar index recorded its worst week in nearly two years last Friday, after the euro settled at its highest in three weeks at the beginning of this week, while the pound rose after strong shifts from ECB and BoE. EUR/USD saw a significant upward shift in price action last Friday (largest one-day move since December 2020) after ECB President Christine Lagarde acknowledged rising inflation risks and declined to repeat earlier guidance that a rate hike this year is highly unlikely. That marks a sharp shift in the tone of monetary policy for one of the world’s most dovish central banks. With that, the decision to raise rates in the Eurozone in 2022, which was previously unacceptable, is now available on the table.
Nevertheless, the euro’s gains will not continue in the short term, with a looming Fed tightening, which will support the dollar strongly.
US economy is improving
US jobs data, stronger than expected, supported the dollar last Friday, pushing the dollar index back to 95.46 after a week full of bruises for the US currency. As the US economy and labor market improve, this will lead the Fed to tighten policies and raise rates at the March meeting.
In the end, the dollar is expected to continue its bullish trend, as it has not reached its peak yet. However, the USD might struggle with some EUR strength with the support of ECB tightening, which may curb its gains. Nevertheless, it will not kill the uptrend.
