DXY Price Hinges on Euro Amid Tensions in Ukraine as CPI Approaches

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US Dollar Fundamental Forecast: Neutral

  • The DXY US dollar index hits a new high in 2022 after the euro tumbled due to tensions in Ukraine
  • Greenback strength persisted after Fed Chairman Powell tempered bets on a 50 basis point rise
  • A lull in hostilities from Russia could see safe-haven flows reverse course and drive the USD

The US dollar soared last week, reaching the highest levels since May 2020, like the situation in Ukraine has deteriorated. This has bolstered the chances that the West will press for additional sanctions against Russia, increasing the already severe supply shock that is disrupting markets. Russia’s attack on Ukraine had a disproportionate impact on the euro, mainly due to the high volume of trade between Europe and Russia. EUR/USD lost almost 3% last week, falling to its lowest level since May 2020. This provides an outsized advantage to the DXY US Dollar Index, which is heavily weighted against the Euro.

Soaring commodity prices have been one of the most important ripple effects of Western sanctions. This reinforced already high inflation expectations in major economies. Germany’s 2-year equilibrium rate – the spread between the yield of the 2-year Bund and its inflation-linked counterpart – hit a record high of 4.24% on Friday. European gas prices extended higher into record territory on Friday. Europe is particularly sensitive to further escalations due to its geographical proximity and trade with Russia. The euro is likely to remain bogged down until the tides turn towards a diplomatic solution, which should support dollar strength in the meantime.

Elsewhere, a strong US jobs report on Friday failed to raise bets for a 50 basis point (bps) rise at the March FOMC meeting. Federal Reserve Chairman Jerome Powell said earlier in the week, “I am inclined to propose and support a 25 basis point rate hike.” Mr Powell reiterated the central bank‘s view that inflation would start to decline after peaking soon, but also acknowledged the current upside risks to inflation. The Fed’s objective is to stabilize prices without inducing a recession, commonly referred to as a “soft landing”.

Nevertheless, the US bond market does not seem so optimistic. US breakevens rose rapidly, with 1- and 2-year rates exceeding 5% and 4% respectively. These are well above the Fed’s target. The consumer price index (CPI) for February is expected to come in at 7.9%y/y on Thursday, from 7.5%y/y in January. It would be the highest number since January 1982. Meanwhile, the yield spread between 2- and 10-year Treasuries accelerated towards the reversal, a closely watched indicator of recession. The measure fell below 25 basis points on Friday. Yet, despite receding rate hike expectations and growing fears of economic stagnation, the US dollar ended the week at a new yearly high.

A currency would typically benefit from its central bank of issue raising rates at a faster pace than expected by attracting foreign investors looking for yield, but as noted, rate hike expectations have weakened and the dollar has continued to climb. The DXY Index is also posting strong gains in the second half of 2021 at a time of relatively muted market volatility, suggesting that higher rates have been largely priced in.

Overall, this points to a likely decline in the US dollar once tensions in Eastern Europe ease, likely largely thanks to a rebound in the euro and a return to global safe-haven flows. into riskier assets. Dollar liquidity could also improve. Banks began hoarding cash, reducing dollar liquidity, as Russian banks cut themselves off from the SWIFT messaging system and sanctions freezing Russian assets spurred a rush for cash.

The FRA-OIS spread, shown in the chart below, is the spread between the interbank lending rate and the federal funds rate, used as a proxy indicator of money market stress. The metric hit its highest level since April 2020 on Friday. All things considered, the US dollar appears subject to a pullback, but the timing depends on a complex geopolitical situation, making it a risky game.

fra ois spread, us dollar, dxy, ois spread, funding costs, liquidity

— Written by Thomas Westwater, Analyst for DailyFX.com

To contact Thomas, use the comments section below or @FxWestwater on Twitter

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