USD: Energy shock supports strength as Fed stays cautious – MUFG

MUFG’s Senior Currency Analyst Lee Hardman notes the US Dollar is trading at its strongest levels since May last year as the Middle East conflict fuels concerns over a prolonged energy price shock that could hit global growth outside the US harder. Fed Chair Powell’s preference to hold rates steady has pulled US yields lower, and potential policy divergence with the ECB and BoE could eventually temper Dollar strength.

Energy risks keep Dollar underpinned

"The US dollar has continued to trade at stronger levels overnight with the dollar index hitting the highest level since May of last year. Renewed upward momentum for the US dollar reflects heightened concerns over the risk of a more prolonged and disruptive energy price shock for the global economy."

"One factor which is not reinforcing US dollar strength like during the last energy price shock in 2022 is the Fed’s willingness to take its time before responding to the energy price shock. Fed Chair Powell stated yesterday that the Fed is inclined to hold rates steady and look through the energy shock triggered by the Middle East conflict."

"However, he did caution that the Fed would be watching inflation expectations closely because a prolonged series of supply shocks could lead businesses and households to start expecting higher prices. At that point, the Fed would have little choice but to act to tighten policy."

"The relatively dovish comments from Fed Chair Powell triggered a correction lower for US yields. The 2-year US Treasury yield has fallen by around 20bps from its recent high at just above 4.00%. Market participants have moved to price back in a higher likelihood of the Fed’s next policy move being a rate cut rather than a hike."

"In contrast, the European central banks of the BoE and ECB are still expected to deliver multiple rate hikes. Normally hawkish ECB Executive Board member Isabel Schnabel did caution though on Friday that they shouldn’t rush to respond to energy price shock and must be careful not to “overreact”."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)