Key Takeaways
- As the Fed awaits actionable data, it continues to indicate inflation is transitory and easy money policies can keep a check on dollar gains.
- Risk-on/risk-off investor sentiment is causing swings in the US dollar with increased FX volatility expected to continue as the post-pandemic economy evolves.
- China levels new regulations on companies across different sectors causing the renminbi to weaken and investors to seek safe haven in the dollar.
Prior to the Federal Reserve meeting on June 17, the US dollar was flat for the year (after a 6% fall in 2020). During July, FX markets looked for confirmation the Fed would signal a tightening of monetary policy. Despite a Fed forecast indicating interest rates may increase by end 2023, comments from Fed governors suggest no time frame has been discussed. Regardless of strong US economic data, in the absence of further Fed guidance, investors may expect USD value to be driven by investor sentiment.
What happened
US economic activity returned to pre-pandemic levels—even though un-biased data pends. As public vaccinations increased and people felt safer going out, second quarter GDP rose 6.5% driven primarily by consumer spending. Year-over-year comparisons however are considered skewed as economic data has yet to show an impact on FX markets. Even so, forecasts for a strong US economy in the second half of the year persist and are keeping investors bearish on the dollar nervous. Further, according to the IMF, the pandemic continues to control much of the global economy since only 40% of the population of the developed world and 11% of the population in emerging markets are vaccinated. FX rates will be affected by the pandemic as countries with low vaccination rates may be forced back into lock-down.
Chinese regulatory measures led to equity and renminbi sell-off. The Chinese renminbi lost roughly 0.7% when it was announced that publicly-traded education companies would essentially be turned into non-profits. The move came after what many investors saw as heavy-handed regulatory treatment by Chinese authorities of some of China’s largest, most successful tech and ecommerce companies. None the less, the renminbi regained lost ground after China rushed to arrange a conference call to explain new regulations are not an indication that other sectors were under scrutiny. China hopes to make the renminbi a more widely used currency, but shocking markets and investors with further regulatory impositions will reduce demand.
Fed concluded the “economy has made progress” and inflation is less of a threat. Importantly, the Fed does not consider this year’s increase in the rate of inflation to be persistent. Fed Chairman, Jerome Powell, stated that bottlenecks in supply have resulted in industry specific price increases, and that once factories are at full capacity and transportation is running smoothly, price increases will stop. Further, temporary inflation will not lead to tighter monetary policy. The Fed’s stance of favoring lower interest rates longer puts pressure on the US dollar, especially if other central banks begin to raise rates sooner.
What’s at play
Inflation. The June reading for inflation (Core CPI) came in at 5.4% over last year. The higher-than-expected reading can be explained by last year’s depressed prices during lockdown and industry specific supply bottlenecks. Despite higher inflation data, consumer expectations around inflation have remained subdued. The University of Michigan survey shows that investors expect inflation in 5 to 10 years from now to be 2.9%. (The same study has averaged 2.8% over the past 20 years). Persistently high inflation will weaken a currency. Since the early 1980s the US dollar has been supported by relatively tame inflation rates; investor sentiment anticipates this will continue.
US-China relations. After last March’s meeting in Alaska, a second meeting in Tianjin, China hoped to strike a more positive tone. Unfortunately, the meeting between President Biden’s team and Xi Jinping’s team saw almost no progress. US Deputy Secretary of State Wendy Sherman said the four-hour discussion was “brutally honest” and her counterpart, Vice-Foreign Minister Xie Feng, described the relationship as “deadlocked.” The renminbi will likely strengthen relative to the US dollar if the two sides can avoid economic reprisals.
What’s next
The debt ceiling could limit supply of US government bonds. The US Treasury is limited by law as to the amount of national debt the country may carry (the debt ceiling). Congress will likely seek to raise the debt ceiling in order to free up the supply of US government bonds. What’s more, the Fed buys US Treasuries as part of its bond-buying policies to support the US economy during post-pandemic recovery. Investors are looking for a place to park cash and Short-term Treasuries (and funds that buy them) are an obvious choice. As treasury yields fall, the Fed has taken emergency action to support overnight rates at 5bps. When/if the debt ceiling is lifted US treasury yields may see a sudden increase. Demand from international investors will likely increase as well if treasuries have a higher yield. Increases in the US dollar would follow.
Investor sentiment will continue to drive USD volatility. The US dollar strengthens with risk-off investor sentiment and weakens with risk-on investor sentiment, such as when equity markets strengthen. In SVB’s Q3 Economic Report, Dr. Ivan Asensio, Head of Risk Advisory, reviews the impact of risk sentiment on USD, and expects more of the risk-on and risk-off movements. Volatility in FX markets will likely continue as the post-pandemic economic recovery spreads around the world. Volatility caused by changes in sentiment highlight the need to manage FX exposures and presents opportunities for companies to lock in favorable exchange rates.
For more information, contact your SVB FX Product Advisor or the FX team at fxadvisors@svb.com.
