Expectations of the most aggressive monetary policy normalization cycle in the US in recent decades have roiled global financial markets this year. As a result, the S&P 500 index has fallen by about 14% from the record highs of early January. At the same time, the greenback rose by more than 7% against its main competitors, including the euro, as traders bet that the Federal Reserve would tighten monetary policy faster than other central banks.
The conflict in Ukraine and anti-bullying lockdowns in China contributed to the strengthening of the US currency, which not only slowed down global economic growth, but also spurred global inflation.
All this led to an outflow of funds from stock markets in favor of a protective dollar, thanks to which the USD index was able to update 20-year highs just below the level of 104.00.
In April alone, the greenback gained about 5%, and the S&P 500 lost almost 8%.
The decline in demand for risky assets provoked the fall of the euro to the lowest values in two decades near $1.0470.
At the beginning of the new month, the dollar stayed near multi-year peaks, leaving the EUR/USD pair under pressure.
Meanwhile, the S&P 500 index reached a new annual low just above the 4100 level, after which it managed to recover by about 100 points.
Nevertheless, investors remained cautious in anticipation of new hints from the Fed about how far and how quickly it is ready to go in terms of tightening its policy, as well as ahead of the release of key data on American employment.
While traders were waiting for the announcement of the Fed's verdict on monetary policy, the dollar consolidated its recent growth on Wednesday, the main Wall Street indices were mainly trading in the red zone, and the EUR/USD pair was trading in the range of 1.0510-1.0560.
After the Fed raised its key rate by 50 basis points for the first time since 2000, following the results of the May meeting, the greenback recorded the largest intraday drop since the beginning of March, having plunged by almost 1%. Meanwhile, the S&P 500 jumped 3% to 4,300.17 points, which was the best result since May 2020. The EUR/USD pair took part in the dollar sell-off and reached the highest level in a week near 1.0630.
The fact is that the US central bank has given softer signals regarding further actions than many market participants expected.
At a press conference, Fed chairman Jerome Powell said that the rise in the cost of lending by 50 basis points will be considered at the next few FOMC meetings. According to him, an increase in the key rate by 75 bps at once is not actively discussed. It became a cold shower for dollar bulls. Based on the futures quotes for the Fed's base rate, the probability of such a move at the next meeting in June was estimated at about 95%.
In addition, Powell pointed out that the exact threshold of the neutral rate is not strictly defined by the central bank.
Powell's comments allowed traders to conclude that the US central bank does not plan to raise the rate at a rate higher than 50 bp.
The central bank's plan to reduce the balance sheet also unpleasantly surprised dollar fans.
The market was based on the fact that from June the Fed's balance sheet will be reduced by 95 billion monthly, and the plan provides for a three-month acceleration to such a volume.
The regularity in raising rates and the central bank's conservative approach to QT served as a breath of fresh air for the US stock market, extending a helping hand to the EUR/USD bulls and putting pressure on the dollar.
"The Fed simply could not (or, better to say, did not) overcome the hawkish bar set by the market. We do not think it would be an exaggeration to say that the central bank's decision was the first dovish surprise from the central bank compared to market expectations in more than six months," NatWest strategists said.
However, the key US stock futures went down on Thursday, losing about 4% on average.
Against this background, the EUR/USD pair quickly lost its positive momentum, failing to stay above 1.0600. Meanwhile, the greenback has put recent weakness behind it, aiming for the top of its recent range around 104.00.
It is obvious that the tightening of the Fed's monetary policy and the reduction of the central bank's balance sheet will lead to an increase in the cost of dollar funding and an outflow of liquidity from the markets, which in the medium term is negative for a wide range of risky assets.
In addition, do recall that the foreign exchange market is not a one-way street.
Even sounding softer than market expectations, the US central bank still remains tougher than its main competitors, including the ECB.
Although investors have somewhat moderate expectations for interest rates in the United States, an increase in the cost of borrowing in the country by another 200 bps by the end of the year remains in quotes.
The hawks in the European Central Bank Governing Council insist on an earlier start of rate hikes. The markets are now laying for a July ECB rate hike, but a blow to the eurozone economy due to the conflict in Ukraine may mean that a later start is likely.The head of the central bank of Finland, Olli Rehn, said that it would be reasonable to expect a rate hike of 25 bps in July, and bring interest rates to zero in the fall.
ECB Chief Economist Philip Lane, in turn, said that the exact timing of the rate hike is not so important now. He noted that the central bank will not change rates immediately, but sequentially. A significant jump in energy prices since the summer of 2021 represents a serious macroeconomic shock, Lane said.
Meanwhile, ECB Governing Council member Fabio Panetta said that it would be imprudent to raise rates before receiving data on eurozone GDP for the second quarter, the first estimate of which will be released on July 20.
"The uncertainty and risks we face are enormous, and no one can reasonably foresee what will happen between now and the end of the year," Panetta said, noting that the eurozone is currently de facto stagnating.
"Economic growth in the eurozone in the first quarter was 0.2% and, in fact, would have been zero without what may have been partly one-time growth spikes in some countries," he said.
"The ECB may end the cycle of negative rates after deciding when to end the QE program in the third quarter," Panetta said.
The Fed is confident that the American economy is very strong and will be able to withstand an increase in interest rates, Powell said.
"Although overall economic activity declined in the first quarter, household spending and investment in fixed assets remained high. Job growth has been good in recent months, and the unemployment rate has dropped significantly," the FOMC said in its final communique.
The euro is still suffering due to the fact that the energy conflict between Europe and Russia is fraught with a cooling of the European economy. The dollar is still benefiting from the influx of funds to safe havens, as the conflict in Ukraine and large-scale restrictions related to COVID-19 in China raise concerns about global growth and new disruptions in global supply chains.
As long as these problems remain on investors' radars, and other leading central banks do not gain the same or greater speed than their American competitor, it is hardly worth waiting for a steady pullback of the dollar.
Westpac believes that the sale of the US currency "on the facts" after the Fed's rate increase by 50 bps is unlikely to change the overall trend in USD.
"The recent decline in the greenback from 103.60 to 102.50 probably indicates more one-sided market positioning than a change in the likely trajectory of the federal funds rate in 2023," the bank's strategists noted.
"The eurozone is struggling with a more acute stagflationary situation, and China is struggling with the COVID-19 outbreak, which has caused severe lockdowns, which reduces the growth expectations of emerging economies. Yield spreads continue to suggest further USD growth in the coming weeks, although perhaps in the second half of the year signs of a slowdown in the US economy may cool the dollar," they added.
"The NFP employment data, as usual, is a "dark horse", but it should not change the overall picture of a stable labor market, which the Fed representatives will emphasize in the coming days in traditional public speeches in the media after the central bank meeting. We believe that the 104 level will still be broken by the USD index in the multi-day/ multi-week perspective," Westpac said.
According to the bank's experts, the economic and political costs of eliminating dependence on Russian energy carriers are likely to affect the growth of the EU and euro economies in the second half of 2022. Thus, the EUR/USD pair can test the 2017 lows at 1.0340-1.0350, they say.
"According to the IMF, abandoning dependence on Russian energy carriers will reduce the growth of the EU economy by 3% in 2023. This pressure on the economy will continue to negatively affect the euro," Westpac said.
"An EU agreement on reducing Russian oil imports is expected this week, but the risks are that an aggressive embargo may force the Russian Federation to limit gas exports in response and thereby exacerbate the energy crisis in the EU," the bank's analysts said.
According to them, if the euro cannot recover quickly above $1.0700, it will remain under threat of further sharp decline and will be able to retest the area of $1.0340-1.0350 (2017 lows), or even the area of $1.0200-1.0250.
MUFG Bank analysts also point to the risks of a decline in the main currency pair, as the problems of EU energy supply remain in the spotlight.
"The negative potential consequences of the conflict in Ukraine continue to put strong pressure on the euro. A more destructive than expected outcome of the situation with gas supplies to Europe will increase the likelihood of the EUR/USD pair falling below the parity level in the coming months," they noted.
The EUR/USD pair remains in the background on Thursday as US stocks fall and the dollar soars, offsetting the losses suffered on Wednesday after the FOMC monetary policy verdict was announced.
"Yesterday's market showed a relief rally. By Thursday, the realities of a more difficult environment for stocks began to be taken into account," said strategists at Principal Global Investors.
The United States reported initial jobless claims for the week ending April 29. The indicator rose to 200,000, which turned out to be worse than the expected 182,000.
According to forecasts, in April the number of jobs in the country's economy increased by 394-400,000, and unemployment fell to 3.5% from 3.6% recorded in March.
Meanwhile, the news coming from Europe was mixed. Germany has announced that it has signed contracts for the chartering of floating terminals of liquefied natural gas to replace Russian supplies. However, the EU has not yet reached a consensus on the embargo on the import of Russian oil.
In terms of data, German manufacturing orders fell sharply in March, down 4.7% month-on-month.
The risk-averse market environment supports the dollar on Thursday, and the EUR/USD pair is losing ground gained on Wednesday. It has already sunk by more than 100 points from the weekly highs recorded earlier.
"It seems that it is too early to be positioned for an orderly normalization of the Fed's policy, which will create favorable conditions for interest in risk in global markets. Instead, problems in both Europe and China create a lot of headwinds for the euro," ING analysts noted.
The initial resistance for EUR/USD is at 1.0560 (50-day moving average). Next, 1.0660 (38.2% Fibonacci retracement level) and 1.0700 (100-day moving average) may come into play.
On the other hand, closing below 1.0560 will lead to testing the psychologically important level of 1.0500, and then 1.0470 (a multi-year low set on April 26).
