US dollar regains upward momentum after sell-off at start of week

EUR: Dovish ECB update weighs on EUR

The euro has continued to weaken after yesterday’s ECB policy meeting. It has resulted in EUR/USD breaking below the low from the end of May at 1.0635. It opens the door to a test of the bottom of the current year to date trading range between 1.0500 and 1.1000. While the euro initially attempted to stage a rally after the ECB decided to hike rates by 25bps and hit a high of 1.0729, those initial gains proved short-lived. The dovish market reaction (click here) to the ECB’s policy update highlights that market participants have placed more importance on both: i) the stronger signal that rates may have peaked and are now more likely to remain on hold for a long period, and ii) the much weaker growth outlook for the euro-zone and lower inflation projections for 2025. The euro-rate market reaction has seen rates increase at the very front end of the euro-zone rate curve (over the next six month period) given that the 25bps hike was not fully priced in, but rates further out have fallen. The implied yield at the end of next year has declined by around 6bps as the euro-zone rate market has moved closer to pricing in three 25bps cuts by the end of next year (currently pricing in 69bps). It highlights that market participants remain unconvinced that the ECB and other major central banks will keep rates at higher levels for a long period as they are increasingly signalling in order to continue bring inflation back towards target.     

The main change to the ECB’s policy guidance was the addition of the line that “based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target”. It sends the strongest signal yet the ECB is close to the peak in their rate hike cycle and is now leaning more towards leaving rates on hold for a long period to help bring inflation back to target rather than continuing to hike rates further. However, President Lagarde did state in the press conference that one can’t say that rates have peaked leaving the door ajar for a further hike if required. The updated policy statement reiterated as well that the Governing Council will continue to follow a “data-dependent” approach to determining the appropriate level and duration of restriction.

The new guidance and weaker growth outlook gives us more confidence that the peak is now in place for the ECB’s deposit rate at 4.00% although history has shown that the ECB can prove sensitive to rising energy prices. The staff projections for GDP growth  were revised significantly lower by 0.2 percentage points to 0.7% for 2023,  by 0.5 percentage points to 1.0% for 2024, and by 0.1 percentage points to 1.5% for 2025. The ECB acknowledged that the increasing impact of tightening financing conditions on domestic demand and the weakening intentional trade environment were the main reasons for the downward revisions to the growth outlook. The weaker growth has contributed to the downward revisions to the headline and core inflation forecasts at the end of the forecast profile. The ECB staff were more optimistic that inflation would then fall closer back to target in 2025 and lowered the inflation projection by 0.1 percentage point to 2.1%. The core inflation forecasts also revised slightly lower for 2024 and 2025 by 0.1 percentage point to 2.9% and 2.2% respectively.  

EUR/USD IS FOLLOWING YIELD SPREADS LOWER

Source: Bloomberg, Macrobond & MUFG Research calculations

USD:  Domestic & external factors help the USD to regain upward momentum

After the pushback against domestic currency weakness from China and Japan at the start of this week triggered a correction lower for the US dollar resulting in the dollar index hitting an intraday low of 104.42 on Monday, the  US dollar has quickly regained  upward momentum by the end of this week helping to lift the dollar index back closer to the March high of 105.88. There have been three main triggers for the quick reversal of US dollar losses. Firstly as highlighted above the ECB has provided a clearer signal that they could have reached the end of their rate hike cycle reflecting in part the significant downward revision to the growth forecast for the euro-zone economies.

Secondly, the PBoC delivered another rate cut ahead of the ECB’s policy decision when they announced that the reserve requirement ratio for banks would be lowered by 25bps. It has been estimated that the reduction in the reserve requirement ratio will release around CNY500 billion of liquidity in the interbank market. At a time when China’s local governments have been stepping up issuance of “special bonds” to finance infrastructure investment. It was the second RRR cut this year and lowers the weighted average RRR for banks will now be 7.4%. While the RRR cut is intended to help provide more support for China’s economy, it will place more pressure on domestic policymakers to prevent the renminbi from weakening as yield spreads between the US and China widen further in favour of a stronger US dollar.

Thirdly the latest US economic data releases have offered support for the US dollar as well. The latest CPI and PPI reports both came in stronger than expected for August, and the retail sales report for August has reinforced expectations for US growth to strengthen further in Q3. While the Fed is expected to leave rates on hold next week, the updated guidance will be watched closely to see if the Fed sticks to plans for one final rate hike this year which if sustained could add to the US dollar’s appeal.  

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
IT	09:00	CPI EU Harmonized YoY	Aug F	5.5%	5.5%	!!
UK	09:30	BoE/Ipsos Inflation Next 12 Mths	Aug	--	3.5%	!!
EC	10:00	Trade Balance SA	Jul	--	12.5b	!!
EC	10:00	Labour Costs YoY	2Q	--	5.0%	!!!
EC	10:45	ECB's Lagarde Speaks				!!!
CA	13:30	Int'l Securities Transactions	Jul	--	12.56b	!!
CA	13:30	Manufacturing Sales MoM	Jul	0.7%	-1.7%	!!
US	13:30	Import Price Index MoM	Aug	0.3%	0.4%	!!
US	13:30	Empire Manufacturing	Sep	- 10.0	- 19.0	!!
US	14:15	Industrial Production MoM	Aug	0.1%	1.0%	!!
US	15:00	U. of Mich. Sentiment	Sep P	69.0	69.5	!!

Source: Bloomberg