US Dollar bounces back amid equity market turmoil
Financial markets were dominated last week by the volatility in equity markets worldwide.
After months of uninterrupted steady rises, stocks finally saw some serious downward pressure, though we note that even at their worst levels last week, indices were still healthily up from the levels of even three months earlier. Currency markets were initially spared from the turmoil. However, later in the week they started behaving in a typical flight to safety manner, lifting the US Dollar sharply higher against all G10 currencies, save the Yen. This week we get inflation reports from the US and the UK. We think the market is vulnerable to any upward surprises in US inflation on Wednesday afternoon. This would probably cause yields to break clearly higher from multi-year ranges, and drag the Dollar higher against all major currencies. Continued volatility in equity markets should also be a positive for the greenback, as risk managers worldwide force the unwinding of the most popular recent currency trades, including the very crowded long Euro positions.
Major currencies in detail
Sterling experienced some serious volatility in the aftermath of a hawkish Bank of England meeting on Thursday. The MPC suggested that market expectations for hikes need to be brought forward, and we are now expecting a May interest rate hike. Sterling surged on the news, before falling back on a combination of EU warnings on Brexit negotiations and the general sell-off in markets. The inflation number for January, to be published on Tuesday, takes added importance given the Bank of England's message. We think the risks are skewed to the upside. A strong number should provide good support for the Pound, particularly against the Euro.
In a dull week lacking in economic or policy news, the Euro largely traded off news elsewhere. While the common currency held on well at first, it seemed to be hit by deleveraging brought about by equity market turmoil and ended the week down over 2% against the US Dollar. The agreement for a Grand Coalition government in Germany did little to support the common currency. This week is also short on news from the Eurozone and we expect the Euro to be driven mostly by technical factors, such as the covering of long Euro positions.
The most clear proximate cause for the global equity sell-off has been the repricing of US interest rate hike expectations, as the entire rate curve is under pressure in the US. Faster wage growth and some upside inflation surprises has forced markets to face the possibility of four hikes from the Federal Reserve in 2018. In this context, January inflation data out on Wednesday looks critical. A continuation of the strong numbers seen recently would probably push the ten-year Treasury yield closer to the key 3% level, which would probably bring about sharp gains in the US Dollar.