The Fed’s dovish communication is acting as a headwind for the US dollar not only because the market’s anticipation that interest rates will remain low for longer, but also because inflation expectations have started to rise. This combination is a clear negative. However, we expect the Fed to shift to a more hawkish stance later in the year, which should support the dollar. Meanwhile, Scandinavian currencies came under heavy pressure as the market adjusted downwards its view on interest rates.
Inflation expectations act as a headwind for the US dollar
Investors interpreted the Fed decision, its statement and the Q&A session as re-enforcing the view that policy rates would not be going up any time soon. As such, they were perceived as having a dovish tilt. This had ramifications for the US dollar.
Emerging market currencies and high yielding currencies outperformed the US dollar since the Fed decision on 18 June.
But what we find most noteworthy is the market’s view about the inflation outlook in the US. Since the start of this week, 5y inflation expectations have risen. The recent higher than expected US inflation numbers and higher oil prices are the key factors behind this trend. However, the Fed’s dovish remarks of course did nothing to change the market perception on inflation. Indeed, inflation expectations continued to rise on Thursday. The current situation in Iraq and higher inflation expectations have hurt the US dollar, because it pushes down real yields. The question remains the question how the trend will develop. At some point in time, interest expectations will also rise mitigating the impact inflationary pressure. If the US economy continues to improve, it will be difficult for the Fed to signal that inflationary pressures are just noise. Therefore, when the Fed comes closer to achieving its dual mandate, the forward guidance will also change. In short, the perception that the Fed is behind the curve acts as a headwind for the US dollar, but we expect the Fed’s behaviour to change going forward. In particular, we expect the Fed to shift to a more hawkish stance later in the year, which should support the dollar.
Scandinavian currencies were out of favour
In general, currency markets had a relatively quiet week last week with the exception of Scandinavian currencies. On Thursday, the Norges bank left interest rates unchanged, but signalled that interest rates could be cut if the economy weakens further. This came as a complete surprise to the market. Therefore, the Norwegian crown came under heavy pressure. On Friday, the currency stabilised somewhat. This news also added pressure on the Swedish krona, despite the stronger than expected Swedish economic data last week. This is somewhat surprising as the market has fully anticipated a 25bp rate reduction by the Riksbank this year. The Riksbank will meet on 3 July and the market is currently positioned for this 25bp rate reduction (see graph). However, with this fully being reflected in the price we continue to believe that the Swedish krona will recover strongly eventually if the global economy and investor sentiment continue to improve in line with our view.
Sentiment on emerging market currencies improved during the week
Emerging market currencies underperformed the US dollar last week, but they recovered after the FOMC meeting, because of its dovish stance. The Indonesian rupiah (IDR), Indian rupee (INR) and Turkish lira (TRY) underperformed due to higher oil prices and the conflict in Iraq (in the case of TRY). It is likely that a higher oil price results in a deterioration in the trade balance and inflation outlook for these countries. Moreover, such development would be a negative for the fiscal outlook, because they have oil deficits and provide fuel subsidies (India and Indonesia). However, as we do not expect a sharp sustainable rise in oil prices, we believe that downward pressure on these currencies due to high oil prices is likely to be temporary. Losses in the INR were limited due to suspected market intervention by the central bank.