The dollar's recent surge is a fascinating phenomenon, and it's worth delving into the factors driving this trend. Personally, I think the market's pricing of Fed tightening and the tech-led sell-off in risk assets are the primary culprits. What makes this particularly intriguing is how these two factors are intertwined, creating a complex dynamic that's shaping the currency market. From my perspective, the dollar's strength is a reminder that cyclical factors are currently dominating the market, rather than structural ones. This raises a deeper question: how sustainable is this trend, and what does it imply for the broader economy? Let's explore these ideas further.
The Dollar's Strength: A Cyclical Dominance
The dollar's broad support is a result of the market's pricing of Fed tightening. The US jobs report has raised expectations of second-round effects from the energy inflation shock, leading to a close to 30bp of Federal Reserve tightening this year and 50bp by the second quarter of 2027. This expected tightening is a key driver of the dollar's strength, as it's pricing in a more aggressive monetary policy stance. However, what many people don't realize is that this pricing is not without risks. At some point, the expected tightening may be too aggressive, and the market may need to re-evaluate its position. This is especially true given the current communication blackout period ahead of the 17 June FOMC meeting, where the Fed doves may push back against this pricing.
The Tech-Led Sell-Off and Emerging Markets
Another factor contributing to the dollar's strength is the tech-led sell-off in risk assets. Investors are selling off benchmark tech names to clear room in portfolios for the upcoming SpaceX IPO, which could also lead to indigestion as Alphabet, OpenAI, and Anthropic plan to IPO in the coming months. This sell-off is particularly impacting emerging markets, with the Swedish krona and the Israeli shekel being the most tech-sensitive currencies in the G10 and EM spaces, respectively. An unwind of risk assets and emerging market positions is normally dollar-positive, and this is likely adding weight to US Treasuries as emerging market nations liquidate Treasuries for FX intervention operations.
Geopolitical Shifts and the Dollar
The geopolitical backdrop is also shifting dollar-positive, with most people surprised that Brent is not trading even higher now that Iran and Israel are directly exchanging fire. This unexpected development is likely to impact the dollar's strength, as it may lead to a re-evaluation of risk assets and emerging market positions. Additionally, Korea's National Pension Service may be selling dollars to increase its hedge ratio on foreign assets, adding another source of dollar selling this week.
The ECB and the Euro
The euro is under pressure due to the dollar's strength, and the European Central Bank is expected to sound hawkish this Thursday when it raises its deposit rate 25bp to 2.25%. This hawkish stance is likely to maintain the view that the ECB will hike again in September when it has a new round of forecasts. However, the risk is that eurozone manufacturing activity data may start to deteriorate after hoarding/inventory building earlier this year around the uncertainty of the Gulf conflict. With energy prices starting to turn bid again, expect the euro to stay offered and 1.1500 to remain under pressure.
The BoE and the Pound
The Bank of England is expected to avoid tightening this year, and the market expects relatively little of the Bank this summer. However, the BoE may price 21bp of tightening at the September meeting, and the release of inflation expectations data among the corporate community gives the BoE some confidence that second-round inflation effects are less likely. In theory, the euro-pound should be trading higher if the BoE is dragging its feet on tightening, but the pound is generally seen as a pro-risk currency with a large financial sector, meaning that it generally underperforms in a risk-off environment. Given the hawkish ECB meeting and the vulnerable equity environment, EUR/GBP is likely to make a move back to 0.8680, while GBP/USD can test 1.3300 and has outside risk to 1.3200 this week.
The CEE Region and the Zloty
The CEE region is following the EM sell-off, and the Polish zloty appears to be the most vulnerable currency in the region, given the dovish National Bank of Poland story. The region saw strong hawkish repricing last week, not only due to Friday's US job data, and market pricing has returned to almost three rate hikes in Poland and almost four rate hikes in the Czech Republic in the one-year horizon. Despite the support of higher local rates, the stronger US dollar is setting the direction for FX in CEE, and the risk-off mood coming from the global equity and rates markets suggests more pain for the CEE region in the days ahead. At the moment, the zloty appears to be the most vulnerable currency in the region, with scope to test the upper end of its current 4.225–4.265 range.
Conclusion: A Complex Dynamic
In conclusion, the dollar's strength is a result of a complex dynamic involving the market's pricing of Fed tightening, the tech-led sell-off in risk assets, and geopolitical shifts. This trend is likely to have implications for the broader economy, and it's important to consider the risks and opportunities associated with this development. As an expert, I think it's fascinating to see how these factors are intertwined and shaping the currency market. It's a reminder that cyclical factors are currently dominating the market, and it's important to consider the broader implications of this trend.
