Hawkish Fed and higher US yields: Why isn’t the USD rallying?
17:00, 18 January 2022
Following a stellar second half of 2021, the US dollar started the new year on a weaker note against other major currencies, contrary to what many investors predicted given the Federal Reserve's policy shift and the sharp rise in Treasury yields.
The DXY index, which measures the US Dollar's value relative to a basket of six major currencies, was trading at 95.5 as of writing, almost 1.5% below its December 2021's highs.
What exactly has prevented the greenback from rallying in the foreign exchange market during the last two weeks?
Expectations for rate hikes
Fed futures pricing indicated at the start of the year that a rate hike as early as March 2022 was already more probable than not. According to data from CME Group's Fed Watch Tool, at the beginning of 2022 investors were giving a 60% chance to start of a rate rise as early as March 2022, and they were already pricing in slightly more than three cumulative rate hikes by the end of the year.
The Fed's hawkish stance, as signalled in its most recent FOMC minutes and public statements, has just reinforced investors' beliefs, although without generating major surprises.
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Tight positioning on dollar
By the beginning of 2022, large speculators' net long bets in the US dollar had already reached their highest level since 2019, as Burton Frierson, Reuters FX editor, recently showed.
USD doesn't always follow cycles
The performance of the US dollar has not always been directly tied to the level of the Fed Funds rate or the start of the Fed's hiking cycle.
The US dollar was unconnected to rising interest rates throughout the past two rounds of the Fed's rate rise cycle. Between the late 1990s and early 2000s, the dollar rose in lockstep with interest rate rises, but between February 1994 and April 1995, the greenback depreciated in relation with Fed rate hikes.
Equity market rotation
Recently, the stock market witnessed a style and country rotation, with investors moving away from growth and technology sectors toward value and cyclical sectors, as well as away from US equity indices toward the rest of the world markets.
Since late November 2021, the fall in the ratio between the Nasdaq 100 (a basket of the 100 largest US tech stocks) and the MSCI World index (a benchmark for the global equity market) has been correlated with the decline in the US Dollar, although this correlation has lessened somewhat in recent days.
Three short-term factors
1. Volatility in equity market may help the USD
Increases in the stock market volatility are related with investors seeking safe-haven assets. Generally, the demand for US Treasuries, and hence for the US dollar, surges during periods of excessive market turmoil.
In the recent past, short but dramatic spikes in the Volatility S&P 500 Index (VIX) have been associated with the USD's positive performance.
2. The Fed's January meeting
The Federal Reserve will convene for the first time in 2022 next week, and is expected to reiterate its aim to begin hiking rates as early as March 2022 in response to rising inflationary pressures. The market will be keenly monitoring the timing of quantitative tightening, since this may have a profound effect on liquidity and investor sentiment in risk assets.
If the Fed surprised markets by suggesting a greater willingness and aggressiveness to reduce its balance sheet, this would probably result in higher Treasury yields, since the Fed would be less committed to renewing maturing securities on its balance sheet.
3. A return in bond yield-seeking
While inflation is increasing quickly, so are Treasury yields. Clearly, notwithstanding inflationary risks, there is a level at which the yield promise of US Treasuries attracts more investor demand. And, given the lower bond yields abroad, US Treasuries remain considerably more appealing than core euro bonds.
Higher yield differential between US and German bonds tempt European investors to seek greater returns on the other side of the Atlantic, putting downward pressure on the EUR/USD exchange rate.