US Dollar Extends Powell-ful Rally after Fed Chair Downplays "Trade War" Risk, Hints at Higher Rates

-USD rallies after Fed downplays trade threat, talks rates.

-Risks to the economy "finely balanced" says Jerome Powell. 

-Fed to continue "gradual" rate rises as economy marches on.

© Dmytro Synelnychenko, Adobe Stock

The US Dollar extended its nascent rally Wednesday, rising broadly against all developed world currencies, after Federal Reserve chairman Jerome Powell downplayed the "trade war" threat to the US economy and suggested the Fed will likely continue raising its interest rate this year. 

In testimony to the Senate Banking Committee, Powell told lawmakers that US economic growth was "considerably stronger" in the second quarter than it was back at the start of the year and that risks stemming from President Donald Trump's "trade war" with China and the European Union are difficult gauge.

America's most senior financial policymaker acknowledged that a prolongued period of higher trade tariffs would be bad for the economy but that, in the short term, risks to US growth are finely balanced. This is because the economy is being supported by tax cuts and other fiscal measures, which are helping to counter fears over the impact tariffs will have on activity.

"It is difficult to predict the ultimate outcome of current discussions over trade policy as well as the size and timing of the economic effects of the recent changes in fiscal policy. Overall, we see the risk of the economy unexpectedly weakening as roughly balanced with the possibility of the economy growing faster than we currently anticipate," Powell says, in testimony Tuesday. 

The US Dollar index was quoted 0.28% higher at 95.25 in London Wednesday morning while the Pound-to-Dollar rate was quoted 0.14% lower at 1.3086. The Euro-to-Dollar rate was 0.22% lower at 1.1627 while the USD/JPY rate was 0.03% higher at 113.05.

America's greenback has now converted a 4% 2018 loss into a 3.16% profit during the three months since the middle of April, following a sustained rally that drew a line beneath a prior 12-month period of heavy losses. Superior economic growth and risk aversion relating to the trade conflict are seen as being behind the move.

The White House recently ordered a range of tariffs be levied against imports of more than $250 billion in imports of Chinese goods. Trump has also placed tariffs on all imports of steel and aluminium from China, Canada, Mexico and the European Union in an effort to reduce the US trade deficit, drawing retaliatory measures from all parties.

The EU responded with its own levies on US motorcycles, jeans and whiskey, drawing threats of even more tariffs from the White House, this time targeting the mighty European automotive sector. Fears are that a tit-for-tat tariff fight will quickly descend into an all out "trade war" and that this will dent economic growth in all countries it touches.

"Fed Chair Jerome Powell’s testimony to the US Senate yesterday gave currency markets a much-needed reality check," says Philip Wee, an FX strategist at DBS Bank, in Singapore. "Looking past the trade war worries meant a stronger US dollar, not vice versa. Powell sees no reason to deviate from the Fed’s gradual rate hike path."

Going into the testimony Tuesday, markets had fretted that Powell might sound more concerned about the "trade war" and outlook for US growth, which prompted the Dollar to fall steadily throughout the day. Although it quickly reversed course and headed northward following the address.

"This suggests limited near term downside risk to USD as the Fed factor is unlikely to be USD negative, though we equally acknowledge that with a fair degree of tightening priced in, Fed policy should not be an active driver for more material USD gains," says Petr Krpata, chief EMEA FX strategist at ING Group. "The potential dollar upside is more likely to be associated with the escalation of trade wars and particularly concentrated against EM FX in such a scenario."

The Federal Reserve has now raised its interest rate seven times since the end of 2015, taking the top end of the Fed Funds rate range up to 2% this June, with the pace of rate rises picking up a touch in the last year as US inflation converged steadily with the Fed's 2% target. 

"After many years of running below our longer-run objective of 2 percent, inflation has recently moved close to that level. Our challenge will be to keep it there. Many factors affect inflation--some temporary and others longer lasting. Inflation will at times be above 2 percent and at other times below," Powell told lawmakers Tuesday. 

Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"USD traders are principally correct to react with relief to Powell’s optimistic economic outlook, as the focus of course still rests on the question of what sort of effect the increasing protectionism will have on the US economy and therefore on Fed policy and the dollar," says Esther Reichelt, an analyst at Commerzbank. "The US dollar has further to fall compared with other currencies whose central banks are still easing (Bank of Japan) or are only just beginning to think about a normalisation (ECB)."

Reichelt says that because the Fed is already deep into the process of normalising its interest rates, in other words returning them to more normal levels after leaving them for years at post-crisis lows, the US Dollar has more to lose if the central bank suddenly changes course. This could happen if the trade war were to become more serious and actually begun to hamper US economic growth. 

"As a result the FX market is likely to judge the meeting between the President of the EU Commission Jean-Claude Juncker and US President Donald Trump in Washington next week positively, when the two parties will look into whether the EU will be able to avoid a further escalation in the tariffs conflict between the EU and the US by reducing tariffs on cars. That would lower the danger of the downside risks of the trade conflict materialising and having an effect on US data," Reichelt writes, in a briefing Wednesday.

President Donald Trump will meet European Commission chief Jean-Claude Juncker in Washington next week to discuss the trade conflict. Markets will listen closely for clues as to whether the meeting resolves differences over tariffs and policy, or if it points to a further escalation in the trade conflict.

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