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Dollar fell victim to two-year rate differential shift

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The dollar is stabilizing as it consolidates losses after the Federal Reserve said Wednesday that it was too early to consider lifting support measures, even though it improved its outlook on the economy.


“The Fed will continue to disappoint anyone expecting a monetary policy that supports the dollar,” said Ulrich Leuchtmann, currency analyst at Commerzbank. “And with each passing day, the rise in the dollar is becoming more difficult to justify.”


This means that there is no fundamental reason for the EUR / USD pair to trade below 1.20, he says. EUR / USD is trading unchanged at 1.2122, hitting an earlier two-month high of 1.2151, according to FactSet. The DXY dollar index was unchanged at 90.6140 after hitting a two-month low of 90.4240 earlier.

Laura Cooper, Bloomberg columnist, notes that after a period of interest rate convergence around effective lower bounds, hints that stimulus could be cut are setting the stage for even greater divergence. This could boost G-10 currencies, with the Canadian dollar and the Norwegian krone at risk of rallying against the US dollar, but other crosses could be better.

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The refusal to buy bonds by the Bank of Canada was accompanied by an unexpected change in its recommendations to raise interest rates, which spurred the Canadian dollar’s rise to multi-year highs. Markets expect rates to rise threefold over the next two years. In contrast, rates on just over one quarter percent rate hike by the Fed were virtually unchanged from expectations a month ago (as of April 27) after aggressive price changes in the 1st quarter propelled the dollar outperforming most of its major peers. … As policy divergences widen, expectations may change as the global economic recovery picks up steam and incentives begin to roll back.

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This is important for FX as even small increases in short-term rate spreads have a huge impact on the currency. Dispersion, historically low during the pandemic, is starting to widen: the weekly movements of the ICE spot dollar index relative to shifts in two-year rates, on a DXY-weighted basis, are now more than double the long-term average.

While the Bank of Canada has previously tightened its rhetoric on the Fed’s rhetoric and is likely to do so again, the ~ 60 basis point rate differential measured on two-year swaps is historically wide. Strong US data and rising inflationary expectations could trigger a turnaround in the Fed’s policy. According to consensus, QE will already decline by Q4, with money markets likely to overestimate rate hike expectations.

Elsewhere, Norges Bank made it clear that it might be the first of the “big ten” to raise its interest rate. Further growth of the kroon may be difficult given the forecast of the rate hike reflected in the exchange rate.

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The Bank of England is likely to cut its bond purchases by June to maintain a buying schedule for the rest of the year. This could lead to a further change in rate hike expectations as the UK lags behind the US in tightening monetary policy. It is prudent to be optimistic about pairs where rates should remain fixed, including the Swiss franc, Japanese yen and Swedish krona.

Meanwhile, the Reserve Bank of Australia’s commitment to hold out until 2024 could hold the front end of the curve. This could mean that the Australian dollar will perform worse against the US dollar. And against the backdrop of tapering by the Bank of Canada, expectations that the RBA will extend quantitative easing may decrease.

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