Dollar near its highs again (Daily analysis 27.01.2022)

The Federal Reserve is moving with confidence towards interest rate hikes that will precede the start of balance sheet reduction. Information after the January meeting of the US monetary authorities is water for the US dollar mill.

The US currency is clearly gaining after the Fed meeting. The EUR/USD dropped towards 1.12, i. e. the lows from Q4 last year.

At first, the deterioration of global investment sentiment was responsible for the jump in the dollar value and the weakening of the emerging markets basket, with a very significant role played by the firing of geopolitical risks around the situation in Ukraine. Now factors related to monetary policy, the piece of the puzzle that traditionally has the strongest influence on the balance of power in the currency market, are taking over. Bold intentions of the Federal Reserve fuel the appetite for the dollar. It is particularly attractive compared to those currencies whose central banks are not thinking about raising interest rates. First of all, we are talking about the euro, the franc and the yen.

However, our currency forecasts assume that the US currency's highs against most currencies are over, and the EUR/USD should return to the 1.15 level in a few months. The dollar may have exhausted its upside potential, but it will remain strong in the current environment. Right now, aggressive interest rate hikes are taken fully into account in the dollar's valuation. This means that investors see chances to start the cycle with a move greater than 25 bps. The most recent data from the economy came out so weak that we see such a move as unlikely. In the last two months, the US economy added fewer than 250 thousand jobs. We should not expect much better results after January, among other things, due to high statistics of coronavirus cases. As a result, monetary policy expectations may become a burden for the dollar.

The dollar: Fed moves firmly towards normalisation

In the past, the Federal Reserve has used its communications to try to smooth out market turbulence and stresses like the current severe slump on Wall Street and global stock markets. The priority right now is to keep inflation from getting out of control. The labour market is in excellent shape, which creates room for bold interest rate hikes without obvious harm to the economy. The combination of 7% price pressures, 4% unemployment, and very strong labour demand is enforcing a continuation of the drift that began a few quarters ago toward a rapid abandonment of pandemic, crisis-ridden policy.

The main tool of tightening will be raising interest rates. The first of these is expected as early as March. Jerome Powell emphasised at the press conference that a rate move is possible at every subsequent meeting in 2022. He also did not rule out increases of 50 bps. At the moment, from the point of view of the markets, the absolute minimum plan includes four rate hikes with a total scale of 100 bps. The macroeconomic situation supports stronger tightening, and the Fed will not hesitate to react to persistently high inflation rates.

Once the cycle of increases begins, the next step will be to reduce the balance sheet, which was inflated by as much as about 4 trillion USD during the pandemic, to almost 9 trillion USD. This is equivalent to more than 35% of the US GDP. In the speeches of members of the Federal Reserve the statement preveils that the optimal size of the balance sheet in relation to the size of the economy is 20%. Reaching such a ceiling may take about five years, of course, assuming that on the way there will be no crisis or recession, which will undermine the plans of the Federal Reserve.