Jane Foley, senior FX strategist at Rabobank, explains that due to the more dovish than expected policy direction by US Fed, the USD initially lost ground yesterday and while interest rates differentials are a core component of exchange rate moves, the drivers of the USD are arguably more complex than another other currency due it is dominance as a global reserve currency.
“For a while it has been our house view that the Fed will hold rates steady this year and that it could start to cut rates in H2 2020. While this undermines the outlook for the USD, there is good reason to expect that the USD will continue to find support in the coming months.”
“According to the IMF in Q3 2018, USDs made up 62% of allocated world reserves. The importance of the USD in global payments system has been used to the advantage the US government. The Trump administration was able to force European companies to comply with its sanctions on Iran due to their needs for USDs and the dominance of the greenback in international payments systems. ECB member Coeure responded to this by accusing the US of weaponising the USD.”
“The USDs key position in the global economy suggests that despite the US’s current account deficit and worsening budget position, the USD is likely to benefit from a safe haven bid on any souring of risk appetite.”
“As long as risky assets are spooked it is likely that the USD will be supported – as is the case this morning.”
“Looking ahead, with the exception of the Norges Bank which hiked rates this morning, most other G10 central banks have either adopted or are expected to adopt a more dovish outlook on policy this year. Not only does this reinforce the fact that fears about slowing growth are widespread but it also suggests that interest rates differentials that favour the USD vs. the rest of the G10 are unlikely to narrow. This factor also should limit outflows from the USD.”
“On a 3 month view we see scope for a move towards EUR/USD1.12 on the anticipation that political risk in the Europe could increase around the time of the May European parliamentary elections. We see scope for a moderately firmer tone in EUR/USD in 2020 on the anticipation that Fed rate cut talk is likely to increase.”