Currencies: The U.S. dollar faces ‘win-win’ scenario as it trades near 16-month high, analyst says

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The U.S. dollar is flexing its muscles as surging inflation is seen pressing the Federal Reserve to move further ahead of its major central bank peers when it comes to tightening monetary policy, and the outlook for rates could set up a “sort of a win-win” situation for greenback bulls, according to one strategist.

The ICE U.S. Dollar Index
a measure of the currency against a basket of six major rivals, rose 0.5% to hit the latest in a series of nearly 16-month highs as it trades at levels last seen in July 2020. The index is up 1.4% for the month and more than 6% in 2021, defying consensus forecasts at the end of last year for an extended slide.

Those recent gains have come as short-term rates have jumped, with the yield on the 2-year Treasury note

ending Friday at its highest level since March 2020 as it posted its largest weekly rise in more than two years. Higher yields relative to major peers makes the dollar more attractive to yield-hungry investors.

Read: Around-the-clock currency market may be in for greater volatility as inflation concerns reverberate, economist says

Long-dated Treasury yields have moved largely sideways, with the yield curve flattening — a move analysts say reflects worries the Fed will be forced to move aggressively to rein in inflation, potentially sparking an economic downturn.

The two scenarios “of either front end rates rising or back end rates rising are both good for the USD,” said Brad Bechtel, global head of FX at Jefferies, in a note, referring to the U.S. dollar, and noting that real, or inflation-adjusted, yields remain low across the yield curve.

“Real rates remain extremely low in both front and back end and any sort of repricing higher here will result in more tailwind for the USD. The USD also [is] likely to continue rising on both the idea that the U.S. is leading the path on the recovery trade and likely to attract inflows related to safe haven bids during periods of risk reduction,” he wrote. “Sort of a win-win for the USD.”

The euro
which accounts for 57.6% of the DXY, was down 0.6% versus the dollar near $1.1382, a loss of 1.5% this month. While the European Central Bank faces a December decision on what to do with its pandemic emergency purchase program, it has adopted a dovish stance. Though ECB President Christine Lagarde has at times struggled to tamp down rising rate expectations, U.S. rates have extended their premium over eurozone counterparts.

The dollar was up 0.1% versus the Japanese currency

at 114.05 yen. The British pound

traded at $1.342, near a 10-month low, having fallen around 2% this month after the Bank of England failed to deliver a widely anticipated rate increase.

See: Powell steers markets through Fed decision as international counterparts struggle

The Fed earlier this month announced plans to begin scaling back its monthly asset purchases and is on pace to wind down the program by mid-2022. Traders, meanwhile, have pushed up expectations for rate increases next year, while the Fed has signaled it sees room to remain “patient” when it comes to liftoff. Market expectations for more aggressive tightening were boosted last week after the October Consumer Price Index jumped to a year-over-year reading of 6.2%, a nearly 31-year high.

Meanwhile, the “only scenario where the USD might lag is if we get a catch-up from the [rest of the world],” Bechtel wrote. “I could see, somewhere down the road, an inflection point where inflation settles and all the rate hikes in EM (emerging markets) attract inflows that suddenly reverses course from some EMFX, but we are not there yet.”

But Javier Corominas, director of macro strategy at Oxford Economics, is penciling in a scenario where the U.S. growth advantage over its peers begins to gradually diminish, in line with the firm’s forecasts. In that case, “the dollar is very likely to top out in the coming months and renew what we expect is going to be a multiyear downward adjustment,” he wrote.

“Indeed, if we stack up the dollar REER (real effective exchange rate) against relative business-cycle dynamics, then the trend, measured as the real GDP growth differential between the U.S. and other advanced economies, is still unfavorable to the greenback,” he said.