The US dollar is coming to a boil after a consensus-defying first quarter rebound now that investor expectations for the Federal Reserve to start raising interest rates by the end of next year are fading, but be prepared for currencies to remain sensitive to rate changes expectations, an analyst warned on Tuesday.

“At the beginning of April, the markets showed a full price of 25 [basis point] Fed rate hike for end of 2022. This month’s revaluation removed about 10bp and the USD (US dollar) sell off followed, “said Adam Cole, chief currency strategist at RBC Global Markets, in a note.

The ICE US Dollar DXY index,
-0.08%,
which tracks the currency against six major rivals, rose 0.2% on Tuesday after trading at its lowest level since early March in morning trading. The index is down more than 2% for April after rebounding 3.7% in the first quarter.

See: Defiantly resilient dollar could become a problem for U.S. stocks – here’s when to be worried

The dollar’s rise in the first quarter and the subsequent pullback is in line with an environment in which it appears that small changes in rate expectations are driving large moves in forex markets – an observation supported by data, said Cole. In fact, currency movements were about three times larger than “normal” for given changes in forward rates.

The analyst highlighted the chart below, which tracks the standard deviation of rates in economies with the 10 most traded currencies.

RBC Capital Markets


He noted that central bank policy rates, as measured by the blue line, are more closely clustered than ever as policymakers around the world have relaxed their policies in response to the pandemic. But 2-year yields, measured by the black line, are clearly starting to diverge as investors start to integrate rate hikes in some markets, particularly the United States, Canada and Norway.

In the chart below, Cole illustrates the dollar’s sensitivity to changing rate expectations. It measures what is known as the beta between variations in the DXY and variations in the 2-year credit spread weighted by the DXY. Over the long term, the beta has averaged 7, which means that a 10 basis point change in the credit spread is usually associated with a 0.7% change in DXY. Recently, after the disruption caused by the early stages of the pandemic, beta hit all-time highs near 20, he noted.

RBC Capital Markets


The chart also reflects a historical pattern which has seen periods of high rate convergence coupled with increasing sensitivity in the currency market to small changes in the rate outlook, Cole noted, with the latest beta trading near current levels in the middle. of the last decade.

Overall, it seems likely that markets will remain very sensitive to small rate changes, he said. And in Cole’s case, it supports a call for a stronger dollar.

Cole noted that RBC expects U.S. rate expectations to recover, pushing the dollar higher, “although you don’t have to be as positive as our economics team,” which forecast two. rate hikes in 2022, “to be moderately positive” on the dollar.


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