The fallout from Russia’s invasion of Ukraine could pave the way for more gains for the dollar, upending investor expectations for a weaker greenback as geopolitical uncertainty and European growth concerns bolster the attractiveness of the American currency.
The U.S. dollar currency index has jumped 3% year-to-date to its highest level in 21 months, buoyed in part by investors seeking protection from market volatility that has hammered stocks around the world and fueled wild swings in commodity prices. Russia calls its actions in Ukraine a “special operation”.
How far it will perhaps depend on the paths taken by the Federal Reserve and the European Central Bank in their efforts to normalize monetary policy. While investors are betting that the Fed is likely to impose several rate hikes this year to combat soaring inflation, many believe the ECB faces a tougher task, with soaring commodity prices posing a bigger challenge. great threat to Europe’s energy-dependent economy.
Bets on a widening yield gap between the United States and the euro zone helped drive the euro close to its lowest level against the dollar in more than two years. The currency was down 0.8% against the dollar on Thursday afternoon despite a surprisingly hawkish shift from the ECB at its monetary policy meeting.
“The view at the start of the year that the euro would appreciate after a few months of dollar strength has receded somewhat,” said Bipan Rai, North American head of FX strategy at CIBC Capital Markets.
The recent price action in both currencies runs contrary to what many investors had expected earlier this year, after hawkish pivotal Fed rhetoric helped the dollar rise 6.3% in 2021. Strategists polled by Reuters in late January broadly expected the dollar to tread water, while forecasting the euro to rise 1.5% over the next 12 months.
“Everything that created this bullish case for the euro earlier this year is now creating a very bearish case,” said Eric Leve, chief investment officer at wealth management and investment firm Bailard.
While Leve had started the year expecting the euro to strengthen at the expense of the dollar, he has now reduced his exposure to European equities and is looking to hedge the currency risk of the euro.
A sustained rise in the dollar could have broad implications for markets and the US economy. Although a strong currency tends to weigh on profits for domestic exporters, it could also help the Fed rein in inflation, which recently posted its largest annual increase in 40 years. Conversely, a weaker euro could exacerbate already high consumer prices in the euro zone.
Markets are pricing the federal funds rate to rise more than 165 basis points in the United States this year, starting with a widely anticipated increase at next week’s Fed meeting. ECB rate hike expectations firmed on Thursday, with markets pricing in an interest rate hike of around 43 basis points this year.
The ECB announced on Thursday that it would end asset purchases in the third quarter and raised its inflation forecast, but also cut its growth outlook.
Nuveen analysts said earlier this month that a Brent crude price of $120 a barrel would sap two percentage points from growth outside the euro zone, compared to one percentage point in the United States, partly due to the country’s larger domestic energy supply and lower taxes.
“There’s a lot more fear on this side of the pond, and I think that’s going to be reflected in the ECB,” Aashish Vyas, chief investment officer at Resonanz Capital, a hedge fund investment adviser based in Frankfurt.
Robin Brooks, chief economist at the Institute of International Finance, wrote earlier this week that the euro may fall below $1.00 as markets adjust to “a major negative shock for the eurozone “. The currency recently traded at $1.0987.
Some believe that the strength of the dollar will subside later this year.
Steve Englander, head of global G10 currency research at Standard Chartered, believes the Fed will make fewer rate hikes than expected and the war in Ukraine will ease, leaving the euro at $1.14 d end of the year.
But in the short term, the euro could suffer a bit more, said Paresh Upadhyaya, director of fixed income and money strategy at Amundi US.
“Just north of parity is likely the bottom of the euro,” said Upadhyaya, who is maintaining a short euro position for now.—Reuters