Why the U.S. dollar is soaring — and what’s next — after Fed’s change in tone

The ICE U.S. Dollar Index DXY, -0.02%, a measure of the currency against a basket of six major rivals, was up 0.9% at 91.94 Thursday afternoon, after trading at its highest since April 13. The dollar is building on a surge versus major rivals scored on Wednesday, after Fed policy makers penciled in two rate hikes by the end of 2023 and discussed the eventual tapering of the central bank’s asset buying program. 

The euro EURUSD, +0.07% on Wednesday dropped below $1.20 versus the dollar for the first time since May 6, and extended its decline 0.8% to trade at $1.1903 Thursday afternoon. The dollar was 0.3% weaker versus the Japanese yen USDJPY, -0.01% Thursday, giving back some of Wednesday’s rise, but remained up 0.6% for the week.

Foley said Rabobank’s existing, contrarian forecasts for a stronger U.S. dollar this summer were based on the view that the debate about inflation and Fed policy would heighten in the approach to the Fed’s Jackson Hole symposium. The dollar index is up 2.2% for the year to date.

The surprise from the Fed’s shift was perhaps most pronounced in the currency markets, reflecting expectations, even among analysts who had been skeptical of calls for dollar weakness, that the Fed would continue to play down inflation fears and put off the discussion of eventual tapering at the June policy gathering.

The dollar strength was blamed for a selloff that sent gold futures GC00, +1.04% down sharply, settling at their lowest since April. Oil futures also stumbled, with the U.S. benchmark CL00, -0.28% slumping 2% after closing Wednesday at a more-than-2-1/2-year high.

A stronger dollar can be a negative for commodities priced in dollar, making them more expensive to users of other currencies.

The Treasury yield curve flattened signifcantly, with the 10-year yield TMUBMUSD10Y, 1.491% down more than 4 basis points at 1.515% and the 30-year bond yield TMUBMUSD30Y, 2.076% off more than 10 basis points at 2.11%. Yields and debt prices move in opposite directions.

Meanwhile, stocks saw a mixed finish to a choppy session Thursday, with the tech-heavy Nasdaq Composite COMP, +0.87% up 0.9% and ending just shy of a record close as the fall in long-term yields appeared to buoy rate-sensitive growth stocks. The Dow Jones Industrial Average DJIA, -0.62% fell 210.22 points, or 0.6%, while the S&P 500 SPX, -0.04% finished just 1.84 points lower, a loss of less than 0.1%.

Brad Bechtel, global head of FX at Jefferies, kicked himself for not sticking to his earlier calls for a stronger dollar.

“As someone who was literally the only USD bull in Q4 and Q1 only to turn mildly USD bearish in Q2, as I expected the Fed to really keep looking through the data until Jackson Hole at least, I am disappointed in myself for not remaining USD bullish,” he said, in a Thursday note.

Bechtel said he expects the dollar to continue pushing higher, though the move seen so far has been extreme, with the currency’s rally doing “two months of work in the space of 12 hours.

“Nothing in a straight line, but I would be buying dips,” the analyst said. “The short term narrative is that the Fed is slowly turning the tanker ship, the commodity space is letting the air out of the bubble, the economy is improving at a rapid pace with a lot of momentum, and the pandemic is largely behind us, and that is therefore a yield positive, USD positive narrative,” Bechtel wrote.

But dollar bears aren’t necessarily throwing in the towel.

“The FOMC meeting lifted the dollar which is not surprising given the Fed’s new median forecast for two rate hikes in 2023. However, a key point is that this could still leave it behind — or not very far in front — of many other central banks,” including Norway’s Norges Bank, the Bank of Canada, the Reserve Bank of New Zealand and the Bank of England, said Steven Barrow, head of G-10 strategy at Standard Bank, in a note.

And since the U.S. inflation threat still seems bigger than elsewhere, “it seems unlikely to us that the dollar can sustain a big rally,” he said.

Standard Bank had previously seen room for the euro to slip into the $1.15 to $1.20 range, but is unlikely to drop below that area as long as inflation is a concern and the Fed risks falling behind the curve, Barrow said.

Economists at Wells Fargo also doubted the staying power of the dollar rally.

“The spike in the dollar has been noteworthy, but in our view, is likely to be temporary and we maintain our view for a softer U.S. dollar over the medium-to-long-term,” wrote economists Brendan McKenna and Nick Bennenbroek, in a Thursday note.

Part of the reason to remain bearish on the dollar is that the Fed’s actual monetary policy settings haven’t yet changed, while foreign central banks across the developed world have already taken, and will likely continue to take, steps to tighten monetary policy, they said.

Like Barrow, they pointed to the Bank of England and Bank of Canada, which have already slowed asset purchases, while Norway’s central bank has brought forward expectations for rate increases. Speculation is also growing around New Zealand’s central bank, with market participants now anticipating it could move to lift rates by May 2022, earlier than previously expected.

“With foreign central banks tightening policy and explicitly signaling future policy changes, and the Fed remaining patient, we expect foreign currencies to attract capital flows,” they said. In addition, foreign growth appears likely to pick up steam, fostering an environment that would likely remain negative for the U.S. currency, they added.