While FX markets have calmed down somewhat, the Federal Reserve is still on an aggressive rate hike path that could see rates in the U.S. rising above 3% next year. Furthermore, geopolitical tensions remain high, and the conflict between Russia and Ukraine could drag on for a prolonged period of time.
From a technical perspective, the U.S. Dollar does appear overbought. Let´s have a look at the Dollar Index (DXY) and its performance since the beginning of the year. The index is up almost 8% year-to-date. The RSI on the weekly chart is signalling overbought conditions, suggesting that the Dollar has already surged to lofty heights.
That being said, the recent economic data is supporting faster monetary policy tightening by the Fed, and there are no immediate signs that their hawkishness might be fading in the near-term. While markets are already pricing in rates rising to 2.75% - 3% until year-end, investors are concerned that the central bank will be forced to accelerate tightening.
The Greenback is also benefiting from strong demand for safe havens as markets remain in risk-off mode. Geopolitical tensions have spiked to their highest level in a while. Unfortunately, the war in Ukraine may not end that soon, and there are fears that it could spill across borders. The impact of Russia´s invasion of Ukraine is already far-reaching, and an overall rise in geopolitical tensions could put the global economy at risk - just as it was recovering from the scars of the pandemic.
What could cause the Dollar rally to stall? Once markets see the Fed´s hawkishness waning, we could see a larger correction in the US Dollar. Since the market is already pricing in an aggressive hiking campaign, it would not take too much to trigger a dovish repricing.
A recovery in risk appetite might cause additional headwinds. Equity markets managed to regain some ground recently, although there might be further turbulence ahead. All eyes are on the technology sector where one-time darlings got crushed.
Against which currencies could the U.S. Dollar have better chances of outperforming?
The Euro has been in a strong downtrend since June 2021. The weakness of the common currency has initially been driven by a dovish and passive ECB. A spike in inflation, the war in Ukraine and bleak growth prospects have created additional pressure. The European Commission recently slashed its economic growth forecast for the euro zone by 1.3 points to only 2.7%.
Meanwhile, inflation is expected to remain closer to 7%. While the ECB has turned somewhat hawkish – it may hike rates as early as July this year – it might end up being a case of too little, too late. It could therefore be only a matter of time until EUR/USD hits parity – the next major bear target.
The short-term outlook for the British Pound remains mixed at best. The dovish repricing after the most recent Bank of England meeting triggered a significant sell-off. Pound traders have shifted their focus from inflation to the central bank´s dramatic warnings about a significant economic slowdown. GBP/USD has been recovering quite slowly from this. While a breakout above 1.25 might trigger a short squeeze, there is an elevated risk of a bull trap being around the corner.
How will the commodity currencies perform?
The Australian Dollar has been suffering from a broad risk-off theme and China´s COVID crisis, which sparked concerns about a slowdown of the economic powerhouse. An improvement in risk appetite could give the Aussie Dollar a boost, but weak economic data out of China could continue to cause notable headwinds in the near-term.
The Canadian Dollar could have it easier in the short-term. The surge in oil prices have kept the currency supported, and there is scope for the Bank of Canada hiking rates more aggressively over the coming months.
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