USD Rally on Pause says BNY Mellon

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U.S. Dollar strength is on hold for now says BNY Mellon just a week after the Dollar index bumped up against 105 and "seemed poised to keep appreciating against most currencies".

"It’s retreated since, however, suffering its worst five-day performance since November of 2022. This has surprised us somewhat, as the volatility in risk markets would usually translate into further dollar strength," says John Velis, FX and Macro Strategist for the Americas at BNY Mellon.

The retreat in then Dollar has released pressure on Sterling and the Euro, both of which have recovered from multi-year lows.

The Pound to Dollar exchange rate has pushed back to above 1.25 following a 1.80% gain last week, but it is the Euro that is outperforming more impressively with Euro-Dollar going back to 1.0680 having been as low as 1.03502 on May 13.

Why has the Dollar's Rally Stalled?

BNY Mellon tells clients in a regular daily currency briefing that expected policy rate differentials between the various global central banks have levelled off for now, stalling the USD's uptrend.

The Dollar had benefited from a dramatic increase in U.S. rate hike expectations courtesy of Federal Reserve guidance that a series of 50 basis point interest rate hikes lie ahead.

But this is now baked into the value of the Dollar and other central banks are catching up; none more so than the European Central Bank (ECB).

ECB Governing Council members have been preparing the market for a July rate hike, but it was ECB President Christine Lagarde's May 23 intervention that cemented a July hike.

She said in an extraordinary blog post that a July hike would be appropriate while another hike by September was also now very likely.

The Euro rose sharply and economists raised their ECB interest rate profiles accordingly.

"We think that this flattening out of the expected policy differential (as proxied by the 2y spreads shown in the picture) has removed a key driver of a higher dollar – for now," says Velis.

Above: 2 year yield spreads and the Dollar index (DXY). Image source: BNY Mellon Markets, Bloomberg.

Can the Dollar's Setback Last?

The Dollar has however not done appreciating says BNY Mellon as analysts don’t believe asset market volatility is complete, and this volatility is "usually the dollar’s friend".

Furthermore, the market will begin to price in higher U.S. yields as further Fed rate hikes are anticipated.

"The next leg higher in the dollar may take a while to materialise. We think it will likely be driven by another leg higher in spreads," says Velis.

"We have been on record arguing that current Fed pricing (which has the Fed funds rate topping out at just above 3% into late next year) is too shallow," he adds.

In fact economists at BNY Mellon believe the U.S. faces a persistent inflation problem heading into the second half of this year and into 2023, which will force a rethink of the policy path.

They see the Fed Funds rate at 4% by this time next year, which is some way ahead of the market (current peak is at 3.05% which is lower than where it was as of May 06).

"This eventual re-pricing of Fed expectations will likely take the dollar higher, after what we view presently as a pause in its ascent," says Velis.

Therefore if BNY Mellon are correct the Pound-Dollar exchange rate's current rally is likely to have its limits before another meaningful leg lower ensues.