What's Next for the U.S. Dollar Amid Cooling Inflation?
Cooling inflation is accelerating the U.S. dollar depreciation. The U.S. dollar experienced sharp depreciation last week due to lower-than-expected inflation in June, falling to its lowest level in over a year. What's next for the U.S. dollar without the support of rate hike expectations?
1. Fed's monetary policy: U.S. inflation hit a 2-year low in June, giving hope that Fed's aggressive rate hike may end early. Besides, the sudden stepping down of "Eagle King" Bullard also deepens the market belief that the Fed's policy direction may have taken a turn. After losing the support of tightening monetary policy, the USD index will face downward pressure.
2. Monetary policy in other developed economies:As the U.S. dollar index is calculated by exchange rates of various developed economy currencies such as the euro, Japanese yen, and Canadian dollar, higher rate hike expectations set by other central banks can also exert downward pressure on the U.S. dollar.
Helen Given, an F.X. trader at Monex USA, predicts that the U.S. dollar's long-term momentum will be weakened as the Federal Reserve is expected to wrap up its rate-hiking cycle ahead of other central banks.
3. U.S. Economic Data: Looking ahead to the second half of the year, economists hold divergent views on the outlook of the U.S. economy. Some analysts predict that the negative effects of aggressive interest rate hikes will surface gradually, leading to a mild recession in either Q4 2023 or Q1 2024. Meanwhile, others are more optimistic and anticipate a softer landing or moderate growth for the U.S. economy.
According to the "dollar smile theory", the U.S. dollar tends to perform well during periods of deep recession or strong growth, as demand for the currency increases. In contrast, if the economy is in a relatively neutral phase, it could lead to weaker demand for the currency, driving its value down. Hence, moderate growth or a mild recession can pose challenges to the fundamentals of the U.S. dollar, potentially intensifying the downward pressure on the currency.
4. U.S. real yield curve: The real yield curve is considered one of the best predictors for the U.S. dollar, as it reflects the real return of foreign investors in U.S. yields that drives the currency at the margin. After peaking last summer, the curve has been significantly flattening, suggesting a further downward trend for the U.S. dollar.
5. U.S. trade deficit & fiscal deficit: The trade and fiscal deficits will also contribute to a weaker U.S. dollar. U.S. trade deficit results in a net outflow of the dollar, putting downward pressure on the value of the currency.Similarly, a surging federal deficit leads to increased borrowing and debt, raising concerns about the country's ability to repay its debt and negatively impacting the U.S. dollar's value. The U.S. budget deficit reached USD 227.8 billion in June 2023, higher than the market expectations of $175 billion.
Some analysts believe that the U.S. economy remains resilient compared with other countries. Although inflation has cooled, the Federal Reserve may not rush to cut rates. Furthermore, potential rebounds in U.S. inflation may increase expectations for a Fed rate hike, limiting the downside risks for the dollar in the near term.
Prince of Bridgewater: "Inflation has come down but it is still too high, and it is probably going to level out where it is — we're likely to be stuck around this level of inflation; The big risk right now is that you get a bounce in energy prices when wages are still strong, which could drive a rebound in inflation." According to Prince, the Fed may keep interest rates high while the market waits eagerly for a rate cut.
Source: DailyFX, Bloomberg, Trading Economics
Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only.
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