The major themes we flagged in last month’s commentary intensified in June and skewed in favor of the US dollar. Specifically, diverging central bank outlooks, a slower, bumpier recovery from the pandemic, and stubbornly high inflation.
The largest market impact came from the surprisingly hawkish shift in outlook from the US Federal Reserve (Fed) on June 16th. The Fed pulled forward the date of its first expected policy rate increase while leaving the long run expected rate unchanged at 2.5%. The policy path based on the Fed DOTS projection now calls for two rate hikes in 2023 up from zero at the March meeting and seven Fed policy makers now see at least one rate hike in 2022 up from four in March. In addition, the Fed Chair Powell indicated that the committee is now talking about tapering the QE program. USD short-end yields and the US dollar moved higher in response.
However, after an initial knee jerk sell-off equity markets and emerging markets handled the news well as the expected terminal policy rate of 2.5% did not change and longer dated US yields fell. There may be a number of technical reasons contributing to the drop longer dated yields, but an important possible explanation is that a more responsive Fed reduces the risk of a severe inflation overshoot which requires the Fed to move more aggressively and potentially raise rates to restrictive levels. Lower risk of a policy error is good for longer-term stability and growth. Going forward we expect the currencies backed by more proactive central banks to hold up better. We now add the US dollar to that list. This should help to support USD through Q3 however USD is already expensive to fair value and that along with other factors that we discuss in the USD section suggest that USD is likely to come under pressure once again later this year and into 2022.