Dollar's Sintra Comeback Leaves Euro and Pound Reeling

Above: Jerome Powell appearance at the ECB Forum on central banking, 28 June 2023 in Sintra, Portugal. © Sérgio Garcia/Your Image for ECB.

The U.S. Dollar rebounded with a vengeance over the course of the midweek session, taking value from the Pound, Euro and all other G10 peers, and setting itself up for a strong finish to what has been a mixed first half of 2023.

Currency analysts are attributing much of the Dollar's most recent comeback to a clear message from Federal Reserve Chairman Jerome Powell that at least two more interest rate hikes can be expected before the current cycle is done.

The Dollar advanced 0.90% against Pound Sterling and 0.45% against the Euro on the day the comments were made at a forum of central bankers in Sintra, Portugal.

Powell said, "although policy is restrictive, it may not be restrictive enough and it has not been restrictive for long enough."

The Fed skipped a rate hike at its most recent meeting and markets were positioned for one further hike, but another additional hike now looks likely given the tone of the Chair's language.

Fed policymakers indicated in June they expected to raise rates at least two more times this year, a commitment that was however not fully appreciated by investors that looked to call the Fed's bluff.

But Powell's message is that the Fed is in fact not bluffing as he left the door open to the central bank raising borrowing costs at two consecutive meetings.

"Broad US dollar strength pulled both GBP/USD and EUR/USD lower yesterday, partly reflecting lower risk appetite and Fed Chair Powell's reaffirmation that the Fed may resume interest rate rises. GBP/USD fell towards 1.26 and EUR/USD moved below 1.09. Both pairs weakened slightly overnight," says Hann-Ju Ho, an economist at Lloyds Bank.

Looking at the performance dashboard now reveals the Dollar to be the top-performing major currency of the past week amidst this rerating in expectations for higher U.S. interest rates.

Above: USD performance over the past week.

"The dollar advanced against nearly all G10 currencies," says Derek Halpenny, Head of Research for Global Markets EMEA at MUFG Bank Ltd. "The near-term performance of the dollar is therefore tied to both Fed monetary policy expectations and global growth performance."

Powell reiterated in the panel discussion on Wednesday that a "strong majority" of Fed policymakers were looking for two more 25 basis point interest-rate increases this year.

The lift in Fed hike expectations comes amidst the settling in Bank of England rate hike expectations which have been on the march higher over recent weeks.

This shift, therefore, returns momentum in the Dollar's favour and helps explain the Pound to Dollar exchange rate's recent decline to 1.2645 from highs at 1.2848 mid-month.

Bank of England Governor Andrew Bailey also spoke at the forum, indicating UK interest rates would likely have to stay 'higher for longer' while pushing back against expectations for cuts in early 2024.

"I've always been interested that the market thinks the peak will be short-lived in a world where we're dealing with more persistent inflation," said Bailey.

Money market pricing shows investors are expecting Bank Rate to peak at, or just above, 6.0% as the Bank grapples with entrenched inflationary pressures.

But for the Pound, these expectations are 'in the price' and analysts foresee potential disappointment for the UK currency if the Bank fails to achieve this lofty target for fear of pushing the economy into recession.

"We maintain that rate hike expectations in the UK are way overdone and at some juncture there will be a marked drop in market rates to coincide with less monetary tightening being delivered by the BoE," says Halpenny.

The Euro to Dollar exchange rate meanwhile retreated to as low as 1.0880 as European Central Bank (ECB) President Christine Lagarde was unable to counter the market-moving content of Powell's appearance.

Lagarde reiterated her opening remarks to the Sintra conference that further rate hikes were needed to get a grip on inflation, but like Bailey, she was unable to really push expectations much higher, leaving the Euro to the whims of a Dollar rebound.

The developments put the Dollar on a firmer footing and investors will now turn focus to the next round of inflation data releases, starting with that of the Eurozone due out Friday.